Evaluating investment risk
By F. Prakash Jerome
Any investment requires a return. If we are saving our monies in a bank savings account, we expect an interest to be paid for our savings. We expect interest as the reward for the risk taken in investing in a particular investment instrument and as compensation for the effect of inflation.
The most important aspect of any investment decision is evaluating the risk. In investment theory risk is different from every day usage. In layman's terms risk is the possibility of failure (the term possibility incorporates uncertainty of return) . However, in investment theory risk is defined as the probability of failure. The distinction is that in theory risk can be calculated. Whereas, uncertainty cannot be calculated. Hence, when investing we must evaluate the risk of an investment. The general rule is the risk and interest are positively co-related: when the risk is high the interest should also be high. So when high interest is claimed, be aware that you will be undertaking the same proportion of risk.
The second aspect is the effect of inflation. Inflation is the loss of value of money over time. If we were able to buy a pen for Rs. 7.50 one year ago and now it is Rs. 9.50, we say that the value of money has decreased. If we calculate the loss over one year it would be 26.67 percent.
When it comes to investment in shares, it must be noted that the reward or return on shares is composed of ;
1. Dividends and
2. Capital appreciation
Investment fundamentally refers to the value of an asset or instrument over the period of its acquisition or ownership. The key driver in the valuation is the return generated by that asset.
In reality we cannot ever predict earnings accurately. Secondly in reality earnings would not be constant. Thirdly, the period of holding the investment will be less than infinity.
What is most important for the retail investor is to understand the current or present market value of the share driven by the future stream of income that is to be derived from it, in the form of dividends and capital appreciation. In reality, however, the daily market values of shares are influenced by the perception or sentiment of the market. However, in the long run the primary value driver would be the company performance. Thus, it is essential that one looks at the business fundamentals of the companies before investing in them.
In order to strike a balance between interest and risk, investors would have to diversify their portfolio in industries which are negatively co-related. If we take tourism and the defence industry, they are negatively co-related. Because one industry's performance would be inversely related to the other. Thus risk is nullified and the interest is averaged out.
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