How to measure risk and return on investments

 

In my previous articles, I have mentioned a lot about risk and return. Actually, what are risk and return and how they are measured?

 

There are two types of risk:

1. Systematic risk- the risk of being invested in an asset class, such as deposit, bonds or equities.

  1. Political risk; the risk of investing in a certain country, such as USA, Japan or HK.
  2. Currency risk; the risk of investing in a certain currency such as yen, sterling.
  3. Market risk; the risk of investing in a certain market such as bonds, stocks.

2. Unsystematic risk- the risk of owning an instrument, such as holding of HSBC shares or
¡@ Sun Hung Kai Properties shares.

  1. Credit risk ¡V business risk, whether the business of the company is growing or declining.
    • Financial risk, whether the balance sheet position is healthy or not.
  2. sector risk ¡V industry risk, whether the banking industry is competitive or not or the profit margin is declining or not.
    • stock specific risk, whether the management of the company is prudent or not.

 

There are also different types of return:

  1. Nominal & real; nominal return is the absolute return of an investment whilst real return is the inflation adjusted return.
  2. Pretax and after tax return.
  3. Total return is the sum of income received plus the capital appreciation of an investment.

 

Risk can be minimized by the following methods:

  1. Diversification

    2. Investing in different asset classes, such as deposits, fixed income instruments and equities can reduce risk of the portfolio, as different asset classes tend to move in a different direction during certain time. For example, bonds tend to go up when the economy is in a recession while equities will go down when the corporate earning is falling.

  2. Internationalization

    3. By diversifying into different countries can also reduce the risk of the portfolio. For example, by investing part of your asset outside Hong Kong into USA and Europe allows you to participate in the growth of these countries when Hong Kong is in recession.

  3. Investing long term

Risk tends to fall with time, as investment tends to move back to their historical mean.

Therefore, by adopting the above strategy can reduce the risk of your investments.

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