The risk-return relationship is vital to invest. The relationship guides the decisions made by investors, both retail and institutional. The principle is always that for a higher level of risk, the expected returns of investors would be high.
In layman terms, it is common to hear investors say the higher the risk, the higher the returns. This is not exactly true. It is more correct to say the higher the risk, the higher the expected returns.
Now, let us explain what we mean by risk.
It is the chance that something would happen and cause the returns from a particular investment to be different from expectations.
As investors, we must also learn how to convert returns that are not quoted on an annual basis such as daily, weekly, monthly, or quarterly returns. For example, an investment that promises 15% in 6 months can be annualized to 30% if the interest is uninvested. If the interest is invested, it becomes 32.3%.
How to measure Returns accurately
The expected return is the profit an investor expects for investing in an asset. Knowing this helps us to assess investment opportunities. This is usually provided by the companies offering the investment opportunity. But always be clear about the duration. Is it per annum, weekly or monthly? This ensures that you can make a comparison with other returns from different investment plans.
The type of return received can also be in different forms. When you buy stocks, for instance, you can receive dividends and capital gains if you sell at a higher price than you bought the asset. Both make up your total returns.
The type of return received can also be in different forms. When you buy stocks, for instance, you can receive dividends and capital gains if you sell at a higher price than you bought the asset. Both make up your total returns.
We earlier defined Risk as the chance of an event that will cause returns to stray from one’s expectations. Let us break this down. If I loan N100 to my friend Bisi and expect to be paid a 10.0% return in a year (N10), anything that can affect the capacity of Bisi to pay me N110 at the end of the year is a risk.
In this example, there is a risk of Bisi losing her job or getting a pay cut. Even though the world is complex, uncertain, and hard to predict, it is your responsibility to gauge risks and invest wisely. Who could have expected the emergence of coronavirus in 2020, for instance? Yet the world feels the impact. Fortunately, we have a sense of certain types of risk in investing by looking at historical performance.
But a note of caution! Investing is about the future; hence your assessment of risk must be forward-looking.
Common myths surrounding Risk
The list is endless but let us look at some.
1. Risk is bad. This is not correct. Understandably, there is a lot of fear around it, but understanding risk ensures that we can take advantage of it. So, it can be an opportunity to make money.
2. You can avoid risk. Again, this is not correct even for risk-free securities. In all your investments, there is a measure of risk.
3. Managing risk is only for experts. This, again, is untrue. Sure, you can delegate this to experts when you invest in funds offered by investment management firms like Afrinvest, but we also make decisions individually, and this means we must be aware of and manage risk.
4. It is not risky because the returns have been predictable. Well, the fact that you have invested over time without the risk factors affecting your investment does not mean you are immune in the future. Investing is more about the future than in the past.
5. You cannot measure risk without data. This is also not true. If it is not measurable or the data is not being collected, you can assess risk factors qualitatively. This may be difficult in some instances, however.
How to measure Risk
Institutional investors and experts use all manner of tools involving statistics and probability, but as retail investors, without high-level skill in these areas, it can be difficult. Yet there are other straightforward ways to look at it.
How important is political risk in determining the nature of one’s investment? How could one mitigate against specific political risk?
We can only look at the ban on motorcycles in certain areas in Lagos to understand how political risk can affect investment. In this case, okada-hailing companies like Max and Gokada invested a lot. Today, the total market they can serve is much lower. For them, it means that the potential earnings from their Lagos operations would be much lower. Mitigating against this type of risk is hard, that is why investors seek clarity before making this type of investment decision.
In countries with a remarkable streak of policy inconsistency, it could be better to look elsewhere. Some firms invest in getting commitments/guarantees from governments to protect against this risk.
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