Here we shall try to explain why do risk-averse persons invest in the stock markets and how do they take decisions regarding the amount of risk they should bear while making investments and planning for the future.
Reason # 1. Assets:
An asset is something that provides a flow of money or services to its owner. A house, an apartment, a savings account and shares of a joint stock company are examples of assets. A house or an apartment produces housing services for its owner.
In case, the owner rents it out, this asset provides a flow of money as rental to its owner. Similarly, a savings account provides its owner with a flow of interest payments per period (a day, a month, or a year). Lastly, the shares of a company provide the owner with a flow of dividends.
The monetary flows from an asset may be explicit or they may be implicit when they take the form of an increase in the price or value of an asset. An increase or a decrease in the value of an asset is called a capital gain or a capital loss. The price of an asset may increase or decrease when, for whatever reasons, demand for the asset increases or decreases.
As the price of an asset goes on increasing, the capital gain also goes on accruing— it is an implicit flow of money. It may be noted that capital gain accrued to an asset may be realised only when the asset is sold. Similar is the case with the capital loss that is suffered by an asset as its price decreases.
Reason # 2. Risky and Riskless Assets:
An asset is said to be risky when it provides a monetary flow that is at least partly random, i.e., at least a part of the monetary flow is not known with certainty in advance. The shares of a company are a very good example of a risky asset.
The owner of the shares does not know in advance whether a positive dividend will be paid, and at what rate, by the company, in a particular period. Again, the flow of income from the shares in the form of capital gain is also random because the rise in the price of the asset is not at all certain or regular.
In contrast, a riskless or risk-free asset is one that provides the owner with a certain and regular flow of income. The bonds issued by the government of a country in the form of treasury bills or the passbook saving accounts are the examples of riskless assets.
Reason # 3. Returns of an Asset:
Returns of an asset are defined in terms of the total value of the flow of money the asset yields relative to its price or value. In other words, the return of an asset is the total value of the monetary flow of the asset including the capital gains or losses expressed as a fraction of the price of the asset.
For example, if the price of a bond is Rs 1,000 and if its yield is Rs 100 per year, then the annual (nominal) rate of return from the bond is 10 per cent.
People generally expect that the nominal rate of return from an asset would be larger than the rate of inflation so that by foregoing consumption at present, they may consume more in future. The rate of return of an asset less the rate of inflation, i.e., the inflation-adjusted rate of return is called the real rate of return.
For example, if the nominal rate of return of an asset is 10 per cent per year and the annual rate of inflation is 4 per cent, then the real rate of return of the asset is 6 per cent (per year).
Reason # 4. Expected Versus Actual Returns:
By definition, the returns from a risky asset are random and so the investor cannot know them in advance. That is why he would have to take the decision to invest in the asset on the basis of expected returns. The expected return of an asset is the average of all possible returns in different periods.
Different assets have different expected returns. It is generally observed in the real world that the low-risk assets like the treasury bills have a low but more or less assured (expected) returns. On the other hand, the high-risk assets like common stocks give the consumer a high rate of return.
That is, the higher the expected return on an investment, the greater is the risk involved. Therefore, the investments of a risk-averse person should be so diversified that there is a balance between expected return and risk.