Higher the risk – higher the return
Lower the risk – lower the return.
This is one rule of investment that is followed by virtually all investors. If you desire better returns, then you have to take more risks. However, it is not all that simple when it comes to implementing it in a financial plan. While it is a universal fact that equity investments are riskier than debt investments, there has to be a way to find out if the returns are worth the risk. This is calculated by Risk-Return Ratio. Here is an example to explain the same:
You invest ₹50,000 and buy 1000 shares of ABC Limited at ₹50 per share. You expect the investment to do well but also want to safeguard against heavy losses. Hence, you decide to sell the shares if the share value drops to ₹40 per share. On the other side, you also want to protect against being too optimistic about the company and decide to sell the shares if the share value rises to ₹70 per share.
So, effectively you risk ₹10 per share to earn a maximum of ₹20 per share. Hence, the risk-return ratio is 10:20 = 1:2.
This ratio can be used by investors to create a portfolio that offers optimum returns for the risk taken.