Understanding Risk and Return

Introduction

Understanding risk and return is a basic concept in investing and finance. Every investment has a degree of risk that can lead to a reward. Being aware of how risk and return are connected will support an investor in making informed decisions and managing their portfolio.

What Is Risk?

Risk is the chance that the return on an investment differs from the return expected by an investor. This means that the risks associated with an investment indicates uncertainty around the future performance of that investment.

Some examples of types of investment risk are:

• Market Risk: Investment values can be more valuable or less valuable based on changing market conditions.
• Credit Risk: A risk that a lender does not repay the borrower.

• Liquidity Risk: When a seller has difficulty selling an asset quickly without losing value.

• Inflation Risk: Increasing prices will lower the real value of one’s return.

What is Return?

Return is the gain or loss that an investor receives from an investment during a specific period of time. Return can take the form of interest, dividends, and/or capital appreciation.
The formula for measuring return is:

Return (%)

Current Value – Initial Value
Initial Value
×
100
Return (%) = (Current Value – Initial Value)
Initial Value
× 100

Returns can be expected (the amount investors hope to earn) or realized (the amount investors actually earn).

Understanding the Relationship Between Risk and Return

There is an inherent relationship between risk and return. Generally speaking, when the potential returns are higher, the risk is going to be higher. The investor must determine how much risk they are willing to accept in order to obtain their desired return in returns. This is also called risk/return trade-off.

Risk and Return Management

Investors can balance risk with the potential for a reasonable return on their investments when they utilize strategies like:

Diversification: Spreading investments over different investments that will reduce risk.

Asset Allocation: Changing the types of investments (equities, bonds, etc.) depending on tolerance levels for risk.

Periodic Review: Reviewing and rebalancing, if needed, to maintain the investment mix in accordance with the financial goals.

Accumulating wealth through mutual funds or ETFs

Introduction

Accumulating wealth through mutual funds or ETFs is a highly efficient and available way for anyone to grow their savings over time. These vehicles provide investors with professional management, diversification, and the effects of compounding – three essential elements to long-term financial success.

Image Suggestion: A simple graph showing the accumulation of money over time or graphic, “wealth accumulating” ladder with mutual funds and ETFs.

What are mutual funds and ETFs

Mutual funds are pooled investments that are managed by professionals who invest the pooled investor’s money in a diversified portfolio of stocks, bonds, or other investments. Investors buy units, or shares, of the mutual fund and receive returns based on the overall performance of the mutual fund in the market.

ETFs (Exchange-traded funds) are somewhat similar to mutual funds but trade on the stock exchanges like shares of stock. They usually replicate or are designed to match a particular index, such as the S&P 500 index (a measure of the entire US stock market) and provide investors flexibility to buy or sell during trading hours (as noted before).

Reasons to Consider Mutual Funds or ETFs for Building Wealth

• Diversification: Both investment vehicles spread your investments across a large number of securities, thereby minimizing risk.

• Professional Management: Saavy managers will invest on your behalf—best suited for new investors.

• Low Cost: You can get started for very little money.

• Liquidity: ETFs can easily be bought and sold, while mutual funds can typically be redeemed as needed.

• Long-Term Growth: With a consistent investment and reinvestment of dividends, your wealth will grow.

How to Start Building Wealth through Mutual Funds or ETFs

Set Well-Defined Financial Goals: Decide what you want to invest for—retirement, education or wealth accumulation.

Determine Your Own Risk Tolerance: Choose funds or ETFs that suit your own risk comfort level.

Start Early and Invest Consistently: Making periodic contributions will allow you to take advantage of rupee/dollar cost averaging and compounding.

Choose Low-Cost Investment Vehicles: Watch out for an expense ratio; the lower the cost, the better or more advantageous it will be for your long-term return.

Review and re-balance as necessary: You should check your investments periodically to ensure you’re investing towards your defined goals.

Mutual Funds and ETFs – Which One Is Right for You?

Select Mutual Funds if you want the benefit of professional management with automatic reinvestment, while also not having to watch the markets daily.

Select ETFs if you want cheap fees, flexibility and the ability to trade during market hours.

Either can be a great option based on your particular investment style and goals for long-term wealth generation.

Conclusion

Building your wealth through either mutual funds or ETFs should not be about market timing, it is all about time in the market. If you are consistent, diversify your investments, and stay focused on the long-term, you can build your financial future and generate wealth toward your goal.