There was a wise man in a smallish town on the banks of a low-profile river. He had (as usual) three sons whom he wanted to teach, among other things, the time-tested principles of managing money.
So one fine day, he summoned all of them and gave them Rs 100 each (this was in old times, so the money was worth quite a lot!). He asked them to 'invest' the money as per their best judgment and report to him.
The first son went to the local representative of the kingdom's treasury and deposited the money there -- which promised to give him Rs 105 after one year.
The second son lent money to a farmer who promised him a 50 per cent share in the farm produce, along with the principal, at the end of the year.
The third son, usually the most enterprising of the lot, had a trader friend who had recently told him about the fortunes to be made by trade in Baghdadi goods in the town and its surroundings. The third son gave his money to this trader with the agreement that he would get half of the profits the trader makes.
As usual, they reconvened to discuss their experiences. The second son was whispering to the first son that it was not fair that third son always wins in these learning-the-profound-principles-practically matters. The wise old man however had a different line of argument!
"You have done well. All of you!"
The third son was taken aback a bit. He was expecting the usual pat on the back and was looking forward to the opportunity of booing his brothers. The sons typically did not interrupt or question the wise old man, for, he was wise as well as old and, not to forget, he was also their father. This, however, was not a 'typical' time. He ventured,
"My investment is most remunerative. The trader is likely to make Rs 80 on each Rs 100 invested. How can you put that in the same league as BigBro's pathetic Rs 105 and MiddleBro's mediocre Rs 140 at best?"
The wise old man smiled his wise old man's smile and spoke in his wise-old-manly manner,
"Agreed. However, your trader may have an accident due to bad weather or his goods may go bad by the time he reaches here or might simply be rejected by the people here because they don't like the goods. On the other hand, MiddleSon's investment is lot less likely to have many of those issues. The farmer he has invested in has been cultivating land and selling his produce for more than 15 years now."
"In that case, why is BigBro's investment at par with MiddleBro's?"
The wise man was still undisturbed. He had expected these questions. It was all falling in place like an unravelling jigsaw.
"Although the farmer is more reliable than the trader, this year's crop may be not as good as an average year's. Or there might be too much of the same crop and people may pay less for the produce or there might be an attack of locusts and so on. On the other hand, the promise of Rs 105 in case of BigBro's investment is certain. The treasury of the king is the most reliable investment, at least in our kingdom."
The three sons nodded in understanding. The elder two were happy to have finally done something which was not inferior to their youngest sibling. Encouraged by this the second son gathered enough courage to ask an intelligent sounding question.
"Then how do I decide whom to give my money?"
The wise man was now smiling from ear to ear. The last piece in the jigsaw had fallen in place. The crore-rupee question (in those times, dollar and millions were still not very popular) had been put forth.
The wise man spoke, "That is the essence of sound money management. You need to ensure that you do not focus excessively on any one extreme in terms of reliability and attractiveness. Do not put all your money with the treasury because you do not need to have perfect assurance on all your money. Do not put all your money with the trader either, because you do not want to be left without any money at all in pursuit of attractive returns. Understand that there is trade-off in attractive investments and their reliability. Find your own level of reliability and attractiveness that you are comfortable with. That, my children, is how you will make the best use of your money. Now, who is cooking supper?"
Thus, the wise old man successfully imparted to his three sons the basic principle of risk and returns and they had a decent supper afterwards.
We would, however, like to expound on the matter a bit further for it to be of practical use to you.
One of the most important assumptions of Modern Portfolio Theory is the relationship between risk and returns. Higher risk is expected to be rewarded with higher returns. While this principle has been at the heart of portfolio allocations of most institutional investors, individual investors have thus far used risk-return tradeoffs only intuitively at best or not at all at worst.
A number for risk!
An objective measure of risk is what is known as standard deviation. It is a measure of the variability of returns on an asset. Simply stated, it means how much wide off the returns can be from the expected average. It is typically calculated over a specified period -- say a year or 10 years.
Once you have the price of an asset for a given period, you can calculate the standard deviation fairly easily. Broad market indexes such as Sensex and Nifty have annual standard deviation of 20-25%, while mid-cap indexes or sector specific indexes have a higher standard deviation of 25-35%.
Single stocks can have annual standard deviation ranging from 30% to as high as 100%. Gold is less volatile and has standard deviation of 10-15%.
The fixed income investments have zero to very low standard deviation, i.e. 0% for FDs (you have fixed returns) or 3-5% for debt mutual funds (almost fixed returns).
Equity mutual funds being diversified across multiple stocks have lower standard deviation than single stocks although amongst them, there is a wide variance.
Better managed funds have lower standard deviation for a given level of annual returns. It is thus imperative to check a fund's risk profile before concluding on the basis of returns alone that it is a good fund.
Return for each extra unit of risk!
Modern Portfolio Theory argues that to take on risks without having adequate returns from an asset is irrational and wasteful. What you need to be aware of is that you are not committing this folly in designing your portfolio.
Often enough we purchase some stocks and mutual funds when we find out from 'sources' that the returns given by them have been high in the last 1-2 years. This is only half the story. You also need to find out if the risk involved in your proposed investment is not too high.
Otherwise you would be left wondering like the third son in the story above why the so-called investment opportunity is not the only one you should wholeheartedly pursue.
http://www.rediff.com/money/2007/may/17money.htm
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