There are several asset classes to consider when investing. These include stocks, real estate, gold, fixed income securities, and more. In India, increasingly now, investors are focusing more on stocks either by directly investing in equity or by investing in mutual funds and Exchange Traded Funds (ETFs).
However, be it any investment instrument, the sole purpose behind investments is the expected returns from it. People invest their money to fetch returns on it and to see it multiply in value over the years so that they can meet their financial goals and build wealth. So, it’s crucial to know how to evaluate the possible returns on a particular investment before putting your money towards it. In the investing world, this is termed as Return on Investment (ROI).
How is ROI usually computed?
ROI is a helpful measure of performance that allows an investor to get an idea of the profitability or efficiency of the investment. ROI is a key thing to consider in any investment decision, irrespective of whether you are investing in stocks, ETFs, or mutual funds via Systematic Investment Plans (SIPs).
ROI is usually computed by subtracting the initial investment amount from the final amount (including returns) and then dividing this by the investment amount. This multiplied by 100 gives you the return on your investment. This is how most investors evaluate ROI in India or rather globally.
What about the risk involved?
While the above method is the most common way to calculate ROI, it has one drawback. The element of risk is not considered here. Irrespective of the security you invest in, there’s always the possibility of negative returns that you may have to bear as an investor.
Thus, it is always preferred to calculate risk-adjusted returns and to know the risk-reward ratio before investing your money in systematic investment plans or stocks. Real returns are what you get after incorporating the risk factor involved in the investment. Real returns, mathematically, can be computed as follows:
Real Returns = Absolute Returns / Risk Incurred
Understand the importance of risk in investments
Now, if you have to choose between two SIP mutual fund investments, one with a 25% return and high risk and the second with a 20% return with low to moderate risk, which would you prefer? In absolute terms, 25% is a more lucrative return. However, it comes with a higher degree of risk as well.
If you think from the risk perspective, for this example, the option of 20% returns with low to moderate risk may seem like a better option once you consider the fact that it generates higher real returns than the first SIP option.
Food for thought
If banks were to start offering 10-12% returns on bank deposits (fixed deposits and recurring deposits) as compared to 15% returns from index funds or equity investments with higher risk, which one would a prudent investor pick? In this case, bank deposits will become more lucrative as they come with negligible risk.
The bottom line is, always consider the risk incurred to earn returns on your investment and calculate the risk-to-reward ratio accordingly. To understand more about the concept of risk-reward in different asset classes and your risk tolerance as an investor, you can consult a financial advisor.