Financial concepts made easy –Risk-Return Ratio

RRR

As the euphoria around Oscars dies down, I would like to take you through my own version of RRR- Risk-Reward Ratio. The risk-reward ratio measures the risk taken by an investor compared to the potential return of the investment. It is calculated by dividing the potential reward of an investment by its potential risk. Say an investor is considering an investment that has the potential to return Rs.1 Lacs but has a potential risk of losing Rs. 50,000/-, the risk-reward ratio would be 2:1.

The risk-reward ratio is an essential tool for investors because it helps them make informed decisions about where to invest their money. When evaluating an investment opportunity, investors should always consider the potential rewards of an investment relative to its potential risks. If the potential rewards of an investment are significantly higher than its potential risks, then the investment may be a good opportunity.

One of the biggest mistakes that investors make is focusing solely on the potential rewards of an investment and ignoring the potential risks. This can lead to poor investment decisions and significant losses. It is crucial for investors to have a clear understanding of the potential risks associated with an investment and to evaluate those risks against the potential rewards.

What you should do: Evaluate your own risk tolerance. Some investors are willing to take on higher levels of risk in exchange for potentially higher rewards, while others may prefer to invest in lower-risk opportunities that offer lower potential rewards. Investors must evaluate their personal risk tolerance and make investment decisions that align with their comfort level.

Let’s understand this with the help of the simplest investment vehicle available in the market, the fixed deposit. Fixed deposits are a great option for individuals who don’t want to take any “risks” with their principal amount.

Liquidity Risks: Fixed Deposits can be withdrawn anytime but you may not get the pledged interest and may be charged a penalty.

What can I do? The easiest strategy to overcome immediate liquidity requirements could be overcome by “laddering” your investments i.e. instead of investing a lump sum you invest over different periods

Bank Default Risk: While comparing interest rates of different banks, you need to understand that if a bank is providing higher rates it may be subject to higher risk.

What can I do? The best option is of course stick to well known banks especially systematically important banks or if the total FDs are less than Rs.5 Lacs then don’t worry; you will be covered by Deposit Insurance & Credit Guarantee Corporation.

Interest Rate Risk: Fixed Deposits have a possibility of locking your investment for a long period of time at a poor rate of return. This is especially true in a rising interest rate scenario where you may face a dilemma to break a FD or to continue for the balance period. Splitting of Deposit amounts over various time horizons could help in such situations or invest in floating rate funds which can take advantage of a rising interest rate in the short term.

Risk of Inflation: Suppose a bank FD offers an interest rate of 5.5 % today, while the prevailing inflation rate stands at 6.5%. Then, under such circumstances, the rate of return that you actually receive on your investment will be lower than the inflation rate. Thus it is important to understand the Real rate of return on your investments. What should you do:While FDs are a good investment vehicle it is important to spread the assets across various investments so that the average returns on your investments beats inflation.

So, if you understandthe RRR in the financial world, you can go “Nattu Nattu”!!

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