Question

Share your thoughts on an investment topic

Answer 1

The question is very generic and subjective. It's a very open ended question. I have structured my thoughts around this and produced the same below. Please use this as a structural framework to devise your own answer.

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An investment is always evaluated on the basis of return and risks it offers. “Risk” and “return” are frequently used terms in the field of corporate finance.

A return is what your investment at any point of time gives back to you at a later time. The simplest way to calculate a return is what you receive till investment horizon over and above what you invested. So, if an investment of value V₀ grows to V_t at the end of investment horizon with intermediate payments in between then

A risk is a probability of unfavorable outcome. All investments are subjected to risks. And all such risks can be broadly classified into two types:

• Systematic risks
• Unsystematic risks.

Table below presents a comparison between the two types of risks.

Sl. No.	Parameter	Systematic Risk	Unsystematic Risk
1.	Nature	Risks inherent inside a system; common to all the entities inside the system; prevalent in every instrument traded in the market	Risks specific to an entity, company or instrument; independent to external changes in economy or politics
2.	Another way to look at it	These are risks associated with the economic, political, sociological and other macro-level changes. They affect the entire market as a whole.	Factors such as management capability, consumer preferences, labour, etc. contribute to unsystematic risks.
2.	Mitigation	Undiversifiable and cannot be controlled or eliminated merely by diversifying one's portfolio.	Controllable; can be considerably reduced by sufficiently diversifying one's portfolio through hedging or right asset allocation strategy
3.	Also known as	Market risk, undiversifiable risk, volatility	Diversifiable risk
4.	Examples	Interest rate changes, inflation, recessions, wars.	Business risks, financial risks

All investments are subject to risk. It is generally believed that investors are rewarded for taking risk. Hence risk and return will go hand in hand. They should not be seen in isolation. It should not be difficult for us to see that a riskier investment should offer higher return to attract an investor. Hence we can conclude that:

1. An investment with higher expected risk should offer higher expected return and vice versa
2. Given same level of expected risk in two investment opportunities, their expected returns should be equal and vice versa otherwise there will be risk return arbitrage

Returns of an investment will fall in a range and may be different under different scenarios. Hence we calculate an expected return which is probability weighted average of returns in various scenarios.

where p_i is the probability of occurrence of scenario “i” and R_i is the return in this scenario “i”

When return is not certain, it will be measured by a measure of central tendency (in this case the probability weighted return or expected return acts as a measure of central tendency) and its various values will have a dispersion around its measure of central tendency. This will lead to standard deviation. Thus, standard deviation of return is a measure of volatility (fluctuation) in the return. It shows fluctuation / deviation / dispersion around the expected return and is mathematically given by

The term inside the square root is called variance. Hence, variance = (standard deviation)². Standard deviation is a measure or expression of volatility in return and hence is representative of risks inherent in the investment opportunity. It’s therefore a measure of total risk (systematic as well as unsystematic).