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The Concept of Risk

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In the previous articles, we discussed about the concept of Investing as a means of putting in money with an expectation of receiving more money in the future. While discussing Investment, we touched upon the concept of time and money. We also touched upon the concept of rate of return/growth.

An important co-related concept to time, money and growth of money is the concept of risk. Risks are the chance of things not turning out the way, you expect it to me. It’s the chance of losing money instead of getting more money in the future. When you make an investment, you expect to earn money but are not guaranteed to do so (which is the risk you take in making an investment).

Essentially, Investment has 2 sides of the same coin (Risk and Reward). Reward is when are able to generate more out of your initial outlay; and risk is the potential loss of your initial outlay resulting in lower capital than before (or loss of money). 

All types of Investments are linked to this concept. Risk rears its head time and time again and is one of the concept that plays with the mind of people. It is important to understand that

“risk is something that no one can eliminate; but is something that you can minimize in whatever you do.”  

An example would be when you are riding a car, there is always a risk of an accident. You can never get eliminate that risk, whether you are riding a Tesla or a Honda Civic.

But you can choose to ride a Ferrari like a Formula 1 driver with high reward at high speeds albeit with high risk or ride a car at a speed of 150 km/hr (sure to get a speeding fine, if not cause yourself an accident – I never recommend this to anyone) on a 90km/hr road. In both of these cases, there are risks associated with it. 

But greats like Michael Schumacher are able to minimise their risk while driving a F1 through skills, experience and learning to come our unscathed each and every time. Only to be hurt while skiing (an unfortunate turn of events, pray he recovers). 

In citing these examples, there are important lessons to take note of 

  1. Risk is something that you can never eliminate
  2. Risk can be minimized
  3. Learning, Experience and Skill helps in minimising risk
  4. Higher the risk, higher the potential reward

Do take note of what I just mentioned above around the 4 specific points on Risks. One thing, you would note is the importance of learning, experience and skill – which is where most people fail at investment; because they fail to learn, fail to take the steps to experience it as they go and they fail to improve their skill in the process. 

In summary, risk is something that you will have to live with; your ability to take more risk without tripping over is directly related to your willingness to learn, experience and develop new skills.   

Concept of Time & Money

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In the last article of Investment we understood what investment is. We will take the concept further to discuss various elements/dimensions involved in understanding investment.

The first and the foremost is the initial outlay. It could by effort, attribute or money. Since, I m more focussed on finance and investment from the perspective of finance, let’s focus our discussions on financial investments from now on.

With this context, the number one element we need to understand is the

1. Initial outlay, money put in or principal (the original sum of money put in).

2. Followed by the concept of time. When you have put in a money with an intention to invest, you would expect it to grow or give you some return over a period of time.

3. And the final thing to understand is the rate of the growth. So, if we have put in some money at what rate has it grown over a period of time.

Most people would understand these basic concepts. Even with a bank account in a savings account, we all know about interest which is nothing but the rate at which my savings (initial outlay) grows.

If we think of an example, let’s start with SK having put USD 100 in a savings bank account with an intention to take it out in a year. The bank gives him 5% interest (USD 5 for every 100 in a year) per annum (meaning per year). In this case, at the end of the year, SK would have USD 105 with him including the interest that has received.

SK has done well considering most banks don’t give that kind of interest 🙂

What we just saw was an example of how investment works. Let’s talk about another example of an investment.

Mr. SK uses the USD 5 that he received from the bank as interest to buy a painting with the intention of selling it when the price of the painting rises.

After 6 months, he sells the paining for USD 30. He has now turned his initial 100$ to 130$ in 1.5 years.

What is Investment?

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The Oxford dictionary defines Investment as “the action or process of investing money for profit.”

In very simple terms, in my mind, to invest is to put something into something to result in an outcome.

For example, you can

  • Invest in a person’s growth by teaching him, educating him
  • Invest time and effort into doing something that help you achieve an outcome
  • Invest money into stocks, shares, property, art, coins etc with an expectation to get something in return in the future.

In essence, investment involves putting in money, effort, or adding to a quality/attribute of a person to enhance the value in general terms.

We will be focussing on the 3rd point above when we talk about investment where the primary goal of putting money is to earn a profit or a return (obviously, you would want to earn more than what you put in).

The reason I talked about getting something in return in point 3 above is because of the idea of getting something in return includes getting

  1. A profit
  2. Or an interest
  3. Or your initial investment + additional increase because of growth or increase in value

Let’s take some examples in the context of money for better understanding of what an investment means:

  • You buy a house with an intention to get rent from it. This is investment.
  • You buy a house with an intention of selling it a higher price in 2 years. That’s an investment
  • You buy a house to stay in there. That’s not an investment as your goal is different. It’s your primary residence and your primary goal here is to live in the house and not gain interest, profit or returns from it.

Similarly, let’s say you buy a painting from Da Vinci with an intention of making millions out of it, that’s an investment.

In the field of shares and stocks, some examples are:

Buying APPLE shares with an intention to

1. Sell it a higher price later earning profit by doing so

2. Getting regular income from shares. Some companies distribute part of their profits with people who own their shares.