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On ground of assurance of the return, there are two kinds of Investments - Riskless and '''Risky'''.


TYPES OF RISK

Depending on the nature of the investment, the type of investment risk will vary.

A common concern with any investment is that you may loose the money you invest - your capital. This risk is therefore often referred to as capital risk.

If the assets you invest in are held in another currency there is a risk that currency movements alone may affect the value. This is referred to as currency risk.

Many forms of investment may not be readily salable on the open market (e.g. commercial property) or the market has a small capacity and can therefore may take time to sell. Assets that are easily sold are term ''liquid'' therefore this type of risk is termed liquidity risk.


PRELIMINARY IDEAS

An investment is carried out for a Return. For example, a person investing $100.00 for one year may expect a Return of $10.00. This means that after one year the person expects to get $110.00 in total. Here, $100.00 that the person invested is called Principal and the excess $10.00 is called Interest. In this particular example, the Rate of Interest is 0.10 or 10% p.a. (per annum).

However, the term 'Interest' is used when the sum of Investment is lended. But, Investment may not always be in terms of Loan. For example, a person may buy some shares of some company. It means a part of the Capital of that company is owned by this person. Now, buying shares is an investment. If the person buys 100 shares @ $500.00 per share, then the person invests $50,000.00. Now, say, after 7 years, the person receives $60,000.00 (it is a very simple and somehow misleading example about the workings of shares, but this simplicity is required for those who do not know about Share Market Operations but want to understand the main context of Investment Risk). It means that the person has earned $10,000.00. This return of excess $10,000.00 is paid out of Profit made by the company.

Now, what will happen if the company incurs a loss? In case of a Loan, the borrower has to pay the interest along with the principal compulsorily. But, in the case of shares, the company cannot be forced to pay a specific amount after a specific period. In case the company incurs loss, the sum of Investment that has been working as Capital in the company will be reduced as Net Loss is deducted from Capital. Therefore, the company, after that 7 years, may pay $40,000.00 and this will indicate that the investor earns a negative return of $10,000.00.

The first example above is a case of Riskless Investment, but the second example is a case of Risky Investment. When a person invests but the sum of return is not assured, it is said that the person is using her assets in Speculation .

The whole thing is best described with the Theory of Probability .


EXAMPLE 1

  • 0.5+$130.00---0.5). Since, none of the two sums is 100% assured, there is a risk of not getting $125.00. However, an investor may not be worried too much since there is no chance of negative return. Theoretically, this is a Risky Investment since the Expected Sum of $125.00 is not 100% assured (it may happen that in stead of $125.00, the investor gets $120.00).



EXAMPLE 2

  • 0.5+$75.00---0.5). In this case, the Expected Return is clearly less than the Sum of Investment and only a Risk-Lover will go on with this.



EXAMPLE 3

  • 0.8+$75.00---0.2). Still, there may be a Risk-Averter who will decide to avoid this investment option.



CALCULATION OF RISK

With help of the same Theory of Probability, the Risk can also be measured. In the above cases, we have measured Expected Returns. We may use the concept of Standard Deviation to measure Risk. Standard Deviation is a measure of Dispersion; it measures how much the different values are scattered from the central or representative value. In the above cases, we may consider the Expected Returns to be the Central or Representative values (they are calculated as Weighted Arithmetic Means where the corresponding probabilities are used as Weights; the sum of Weights being 1 has not been mentioned in the denominators of the expressions). Standard Deviation for a Probability Spectrum (technically called Probability Distribution ) can be expressed as \sqrt{E(X^2)-E^2(X)}; where X: different values of the variable (in our examples, the different sums of return) and E(X): The Expected Value of X calculated from its Probability Spectrum. E(X^2): The Expected Value of X^2 values with the same probabilities as the X values. Standard Deviation calculated from a Probability Spectrum is called Standard Error. The Square of Standard Deviation (and Standrd Error) is called Variance. Higher the Standard Deviation, higher will be the scatteredness of the values and higher will be the risk. In case the different returns are very close to the Expected Return, risk is low. However, the term "very close" is relative. For example, the values 100, 200 and 300 have Arithmetic Mean 200 and Standard Deviation 81.65 (approx.) while the values 199, 200 and 201 have the same Arithmetic Mean 200 but Standard Deviation is 0.82 (approx.). The second set of data is more consistent. If these figures represent returns in two investment options, the second option is better since the risk is lower for it (assuming all the returns have 33% chance).

P(X=A): The Probability that the variable X will take the value A (which is some constant like 15, 0.25, -93 etc.). Now, for the first case where P(X=$120.00)=0.5 and P(X=$130.00)=0.5, the Standard Deviation will be $5.00 (The Risk). In the second case, P(X=$120.00)=0.5 and P(X=$75.00)=0.5, the Risk is $22.50. In the third case, P(X=$120.00)=0.8 and P(X=$75.00)=0.2; Risk is $18.00.

A person may be Risk-Neutral , Risk-Lover or a Risk-Averter . It depends on their personal taste.