Defining risk to minimize it.

Risk & Return

Risk is defined as the uncertainty or deviation in the return expected from an asset class. This risk could be measured in terms of standard deviation of an asset class. Risk can be classified as below:

Systematic Risk

Systematic risk is defined as a risk that takes place in all the risky assets because of macro-economic factors like earthquakes, floods, war, etc. However, it cannot be eliminated through diversification.

Unsystematic Risk

Unsystematic risk is defined as a risk that is unique to a particular asset class and can be eliminated or reduced by diversifying a portfolio.

A security's return is calculated by its holding-period return: the change in price plus any income received, expressed as a percentage of the original price. An improved measure would be to take into consideration the timing of dividends or other payments, and the rates at which they are reinvested. The total return on an investment has two components: the expected return and the unexpected return. The unexpected return comes about because of unanticipated events. The risk from investing stems from the possibility of an unexpected event.

Relationship between risk and return

A simple relationship exists between risk and return – the higher the potential return, the higher the level of risk involved. Whilst everyone would like to maximize return and minimize risk and would prefer to have a return every year of approximately 15-20% with no opportunity of investments falling in value, the reality is that these investments do not exist. As a common rule, the bigger the potential investment return, the higher the investment risk and the longer the investment time horizon.

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