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Risk vs. Return

, March 1, 2013, 0 Comments

Investment is all about risk and return, and ironically both are two sides of the same coin. These two building blocks of investment decision making remain elusive to most investors and not surprisingly they have lost loads of money and wealth. Even those who have comprehended well have lost to the market and those who have understood risk well have made money. The idea, Margin of Safety, propounded by Benjamin Graham and followed religiously by Warren Buffet is another way of amplifying risk and making adjustments to price accordingly.

Risk vs. Return

What is Risk?
In simple term risk is the capital the investor might loss. More formally risk is the variability in cash flows or asset price, higher the variability riskier is the asset and vice versa. Let us look at two assets Asset A and Asset B that were quoting at same price of Rs. 10 in T and thereafter price evolutions of both assets are as shown in the chart below. We see that Asset B has touched the high of Rs. 18 while Asset A could muster Rs.14 which makes the former more enticing but two periods later we see while Asset A is at Rs. 10 Asset B has dropped to Rs.8, a loss of 20% while the former neither made a profit or loss. While the price of Asset B varies between a wider band and generates extreme returns Asset A trades in narrower price band and generate returns of lesser range. Since price of Asset B fluctuates more than Asset A the former is considered riskier.

Though there are few metrics of risk the most prominent of them all is the ubiquitous standard deviation but the simpler metric despite its shortcoming is the ratio of difference between high and low for a given period and the average for the period

That is,High price for the given period – Low price for the given period= Average price for the given period
For Asset B, the high is 19, the low is 8 and the average is 13 which shows the variability of 85% and for Asset A it is 34% which is relatively very low and less risky.

There are other measures of that will be dealt with in next week

High returns promised and Ponzi schemes
Fly by night investment companies or as some call it as blade company tempt gullible investors by promising high returns but neither disclose the risk nor investors ask about the risk once they are blinkered by mouthwatering returns promised by the operators. For instance in the case of StockGuru a scheme which cheated investors crores promised a monthly return of 20% for six months and refund of the principal in the seventh month i.e. scamsters promised a return of 198% in 6 months a kind of return which is impossible for any asset class to return yet may investors lost nearly Rs. 500crs. Had investors asked few relevant questions they wouldn’t have lost their wealth and savings.

Another scam that gained notoriety in 2012 was the Emu Farm in the state of Tamil Nadu. The operators of the emu farming promised a return of Rs. 300,000 every year on time investment of Rs. 300,000 that is 100% every year. The gullible investors were lured by extremely high returns promised by the scamsters and thousands of them failed to ask the fundamental question, “Who is buying emu meat?”.

Both the above examples of scams are Ponzi schemes. We will explain about this scheme next week