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The Risk-Return Trade-off
The most important relationship to understand is the risk-return trade-off. Higher the risk greater the returns/loss and lower the risk lesser the returns/loss.

Hence it is upto you, the investor to decide how much risk you are willing to take. In order to do this you must first be aware of the different types of risks involved with your investment decision.

 
Market Risk

Sometimes prices and yields of all securities rise and fall. Broad outside influences affecting the market in general lead to this. This is true, may it be big corporations or smaller mid-sized companies. This is known as Market Risk. A Systematic Investment Plan (“SIP”) that works on the concept of Rupee Cost Averaging (“RCA”) might help mitigate this risk.
 
Credit Risk
The debt servicing ability (may it be interest payments or repayment of principal) of a company through its cashflows determines the Credit Risk faced by you. This credit risk is measured by independent rating agencies like CRISIL who rate companies and their paper. A ‘AAA’ rating is considered the safest whereas a ‘D’ rating is considered poor credit quality. A well-diversified portfolio might help mitigate this risk.
 
Inflation Risk
Things you hear people talk about:
“Rs. 100 today is worth more than Rs. 100 tomorrow.”
“Remember the time when a bus ride costed 50 paise?”
“Mehangai Ka Jamana Hai.”
The root cause, Inflation. Inflation is the loss of purchasing power over time. A lot of times people make conservative investment decisions to protect their capital but end up with a sum of money that can buy less than what the principal could at the time of the investment. This happens when inflation grows faster than the return on your investment. A well-diversified portfolio with some investment in equities might help mitigate this risk.
 
Interest Rate Risk
In a free market economy interest rates are difficult if not impossible to predict. Changes in interest rates affect the prices of bonds as well as equities. If interest rates rise the prices of bonds fall and vice versa. Equity might be negatively affected as well in a rising interest rate environment. A well-diversified portfolio might help mitigate this risk.
 
Political/Government Policy Risk
Changes in government policy and political decision can change the investment environment. They can create a favorable environment for investment or vice versa.
 
Liquidity Risk
Liquidity risk arises when it becomes difficult to sell the securities that one has purchased. Liquidity Risk can be partly mitigated by diversification, staggering of maturities as well as internal risk controls that lean towards purchase of liquid securities.
You have been reading about diversification above, but what is it?
Diversification
The nuclear weapon in your arsenal for your fight against Risk. It simply means that you must spread your investment across different securities (stocks, bonds, money market instruments, real estate, fixed deposits etc.) and different sectors (auto, textile, information technology etc.). This kind of a diversification may add to the stability of your returns, for example during one period of time equities might underperform but bonds and money market instruments might do well enough to offset the effect of a slump in the equity markets. Similarly the information technology sector might be faring poorly but the auto and textile sectors might do well and may protect you principal investment as well as help you meet your return objectives.


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