Measures of risk

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FAQ's for small investors

What is return?
Return is income earned on the investments. In stocks income is earned either by way of dividend or capital gain.

What is risk?

Risk is the uncertainty that you may not earn your expected return on your investments. For example, you may expect to earn 20% on your stock mutual fund every year. But your actual rate of return may be much lower.

For example, the S&P 500 index averaged yearly gains of about 20% for the five years that ended in 1999. In 2000, however, the index declined more than 9%. Bonds, meanwhile, performed better than stocks for the first since 1994.

What is risk -return trade off?
The risk-return trade-off requires that you accept more risk in exchange for the chance to earn a higher rate of return. If unwilling, you should expect to earn a lower return. Conservative investors, for example, are less willing to lose 10% of their investments in exchange for the chance to earn a higher rate of return. Aggressive investors, on the other hand, are willing to accept this risk in exchange for the chance to earn higher returns
Rate of return: An investor who is unwilling to accept a higher degree of investment risk in exchange for a chance to earn a higher rate of return. Investment risk is the volatility of investment returns. A basic investing principle states that a higher degree of investment risk is required to earn a potential higher rate of return

What are different types of risk?
Ans:
Major types of risk include:
Investment risk. Investment risk is the chance that your investment value will fall. Standard deviation is commonly used to measure investment risk. It shows a stock or bond's volatility, or the tendency of its price to move up and down from its average. As standard deviation increases, so does investment risk.
Market risk. Market risk is the chance that the entire market where your investment trades will fall in value. Market risk cannot be diversified. ll securities are exposed to market risk including recessions, wars, structural changes in the economy, tax law changes, even changes in consumer preferences. Market risk is sometimes used synonymously with systematic risk.
Interest rate risk. Interest rate risk is the chance that interest rates will change while you hold an investment. Higher rates result in lower returns on stocks and bonds, but higher returns on interest-paying investments.

Inflation risk. Bonds are especially vulnerable to inflation risk. This is because a bond's coupon payment is usually a fixed amount. When inflation rises, the present value of the coupon falls. Stocks have less risk since dividends can be adjusted for inflation.

Industry risk. Industry risk is the chance that a set of factors particular to an industry group drags down the industry's overall investment performance. For example, cold weather might adversely affect the retail industry. Or a cutback in capital spending might adversely affect the information technology industry.

Regulation Risk

Some investments can be relatively attractive to other investments because of certain regulations or tax laws that give them an advantage of some kind. Municipal bonds, for example pay interest that is exempt from local, state and federal taxation

Credit risk. Credit risk is the chance that the company selling bonds is unable to make debt payments. As a result, the company may default on its debt or have to file for bankruptcy.
Liquidity risk. Liquidity risk is the chance that your stock or bond investment cannot be sold easily because of a lack of buyers. Such a security is called a thinly-traded security. As a result of ...