Risk and return

150 terms · each links to a full explanation with a worked example and the exam traps

Absolute returnThe plain rupee gain or loss from an investment relative to what was invested — simple to compute, but it ignores both the amount invested and the time taken to earn it.
Absolute-return benchmarkA fixed percentage return, set by the manager when the scheme launches, against which an absolute-return strategy is judged instead of a market index.
Adverse selectionThe risk of ending up with the wrong manager — picking a fund on a track record or a forward-looking statement that does not predict performance, and getting sub-optimal returns or moral hazard instead.
AlphaThe return a fund earned above what its beta and the benchmark say it should have earned — the slice of performance left over once the market has been given credit for its share.
Alternative BetaThe view that much of the "excess" return from taking on unsystematic, alternative-asset risk is really systematic exposure to a different set of risk factors, not true manager skill.
Anchoring biasA cognitive error in which people rely too heavily on an initial piece of information — a purchase price, a past high, a first quote — and judge everything afterwards against it.
Annualised returnA return scaled up or down to a one-year basis so that investments held for different lengths of time can be compared — a simple scaling that, unlike CAGR, ignores compounding.
Arbitrage Pricing TheoryA multifactor alternative to CAPM, developed by Stephen Ross, in which expected return depends on several risk factors — each with its own beta — instead of the market alone.
Arithmetic Mean ReturnThe simple average of a series of period returns. It is the best single guess for next year, but it overstates what a multi-year investment actually grew at.
Basis riskThe risk left over after hedging, because the exposure and the contract used to hedge it do not move identically — in size, in expiry date, or in what they are written on.
Behavioural financeThe study of how psychology shapes the decisions of market participants, individually and in groups, and how those decisions show up as gaps and anomalies in financial markets.
BenchmarkThe independently published index a scheme's performance is measured against, chosen to match its investment objective, asset allocation and strategy, and disclosed in the Scheme Information Document.
BetaHow sharply a share moves relative to the market index — beta 1 moves with the index, above 1 amplifies it, below 1 dampens it. The standard measure of systematic risk.
Beta ManagementThe manager's job of keeping a fund's systematic risk in line with the strategy stated in its private placement memorandum, rather than letting the portfolio beta drift with the market.
Borrowing (leveraged) portfolioA portfolio built by borrowing at the risk-free rate and investing the borrowed money, plus the investor's own wealth, in the market portfolio — plotting to the right of M on the Capital Market Line.
Bounded rationalityHerbert Simon's idea that people with limited time, information and processing ability settle for a satisfactory and sufficient choice — they 'satisfice' — instead of finding the optimal one.
BubbleIn Kindleberger's description, a sharp, continuous rise in an asset's price in which early gains create expectations of further rises and draw in speculators seeking trading profits.
Business riskThe variability of a firm's income flows caused by the nature of its business — driven by how volatile its sales are and how much of its cost base is fixed.
CAGRThe single smoothed annual rate at which a starting value would have to grow, compounding each year, to reach the ending value over a given period.
Call riskThe risk that a bond is called — redeemed by the issuer before maturity. Most prevalent when interest rates fall, and it usually goes hand in hand with reinvestment risk.
Certainty Equivalent RateThe rate a risk-free investment would have to offer to be exactly as attractive to an investor as a given risky portfolio — lower than the expected return for a risk-averse investor.
Compounded returnThe single yearly rate at which an investment's starting value would have to grow, each year's growth earned on the year before, to reach its ending value over a stated number of years.
Compound interestInterest earned on the original amount and also on the interest already earned. Rs 1,000 at 9% grows to Rs 31,409 in 40 years compounded, against Rs 4,600 with simple interest.
Concentration riskThe risk that a few positions are large enough, against the fund's capital, that one loss damages the whole portfolio — capped by SEBI at 25% of investable funds for Category I and II AIFs and 10% for Category III.
Country riskThe extra political and macroeconomic risk of investing outside an investor's home market — priced in as a country risk premium, usually higher for developing countries than developed ones.
Country Risk PremiumThe extra return an investor demands for putting money into one country rather than another, added to the required rate of return to pay for that country's political and macroeconomic risk.
CovarianceA measure of the degree to which the returns of two assets move together relative to their own averages — the building block of portfolio risk, standardised into the correlation coefficient.
Credit riskThe risk that a borrower fails to meet its obligations on a debt instrument — the risk credit rating agencies exist to grade, and the one that triggers a segregated portfolio in a mutual fund.
Cross sectional diversificationHolding equities across different industries, sectors and geographies at a given time, so that sector- and company-specific risks offset. It cannot remove market risk.
Diminishing marginal utility of wealthThe idea, underlying Modern Portfolio Theory, that each additional rupee of wealth adds a little less satisfaction than the rupee before it — the reason most investors are risk averse.
Direct AlphaThe IRR of an AIF's cash flows after each has been compounded at market index returns to the valuation date — the fund's out- or under-performance of the market expressed directly as a rate.
Disposition effectInvestors' tendency to sell winning investments too early and hold losing ones too long — named by Shefrin and Statman (1985) and rooted in loss aversion.
DiversificationSpreading an exposure across holdings that do not move together, so that total risk falls by more than total return does — minimising risk per unit of return.
Downside riskThe probability of a loss on account of falling asset prices in changing market conditions — the half of volatility investors actually mind, measured by maximum drawdown and value at risk.
Endowment biasAn emotional bias in which people value an asset more simply because they own it — its two attributes are valuing ownership and loss aversion.
Estimation riskThe potential for error that comes from having to estimate the returns, risks and correlations that feed portfolio optimisation — the output is only as accurate as those statistical inputs.
Ex-ante returnThe forward-looking expected rate of return: the sum of the possible returns multiplied by their probabilities. The opposite of ex-post return, which is computed from historical data.
Exchange Rate RiskThe risk that an investment’s value, measured in the home currency, changes because foreign exchange rates move. A falling rupee raises returns on foreign assets; a rising rupee cuts them.
Expected Portfolio ReturnThe weighted average of the expected returns of the holdings in a portfolio, each weight being that asset's share of portfolio value — the return half of Modern Portfolio Theory.
Expected utilityThe satisfaction score an investor is assumed to assign to each possible outcome of an investment, weighted by the probability of that outcome — the quantity Modern Portfolio Theory assumes investors actually maximise.
Ex-post returnA return calculated from historical data — what an investment actually earned — as distinct from the forward-looking, probability-weighted ex-ante return.
Fair gameAn investment opportunity that offers no risk premium at all — an equal chance of gaining or losing, with nothing extra to compensate for the risk taken — which a risk-averse investor is assumed to reject.
Financial RiskThe extra variability in shareholders' income created by financing assets with debt — because interest is a fixed claim that must be paid ahead of anything reaching the owners.
Framing biasA cognitive error in which a person answers the same question differently depending on how it is presented — for example, "0% fat" versus "100% fat free".
Frontier marketsThe smallest, least developed tier of emerging markets — high political risk, illiquid and small, but potentially high return — sitting below developed and ordinary emerging markets in country-risk analysis.
Geometric Mean ReturnThe single constant yearly rate that would turn the starting value into the ending value — found by chain-linking period returns and taking the nth root.
Geopolitical riskThe risk that international conflicts, sanctions, trade disputes or diplomatic tensions disrupt trade, supply chains and investor confidence, causing market volatility and losses.
Gross IRRAn AIF's IRR computed on fund-level cash flows before management fees, incentive fees, fund expenses and taxes — the return the portfolio earned, not the return investors kept.
Gross returnThe total return on an investment before deducting any fees, expenses or commissions. Useful for broad evaluation, but misleading as a measure of what the investor actually earns.
I-BexICICI Securities' Sovereign Bond Index, built on government securities — an umbrella index for the whole market plus three maturity sub-indices, Si-Bex, Mi-Bex and Li-Bex.
Illiquidity risk premiumThe extra return investors demand for holding an unlisted or thinly traded investment, to compensate for not being able to buy or sell it quickly at a fair, continuously-updated price.
Illusion of controlThe belief that familiarity, information access or active involvement gives an investor influence over a price — which leads to a conviction that he can forecast it and sell out before everybody else.
Imperfect hedgeA hedge that cannot fully offset an exposure because the contract is standardised — fixed lot sizes, a fixed expiry date and cash settlement leave a remainder the hedger keeps.
Inflation riskThe risk that the money an investment pays out will be worth less in goods and services than expected, because prices have risen — highest in fixed-return products and most damaging to retirees.
Informational EfficiencyHow fully and quickly security prices reflect available information. It is what "market efficiency" usually means, as against operational efficiency, which is about transaction costs.
InsuranceThe risk-management approach that pays an explicit upfront premium to remove the downside while keeping the upside — which in derivatives means buying an option rather than selling a future.
Interest rate riskThe risk that an investor in a debt instrument loses return because rates rise — existing instruments carrying the old, lower coupon fall in value until their yield matches the new market rate.
Internal contradiction of efficiencyThe paradox that a market can only become informationally efficient if enough participants believe it is not — because it is their search for mispricing that drives prices to fair value.
January effectA market anomaly in the US: year-end tax selling pushes prices down in late November and December, and the buying back in early January pushes them up — a pattern inconsistent with market efficiency.
J CurveThe shape of a private fund's returns over its life: negative in the early investing years because of fees, expenses and unripened investments, then rising steeply as exits and distributions arrive.
Kaplan-Schoar Public Market EquivalentA market-adjusted TVPI: capital calls, distributions and NAV compounded at an index's returns to the valuation date. Above 1 means the AIF beat the market; below 1 means it lagged.
Keyman riskThe risk that a company depends so heavily on one or a few individuals that a change at the top can derail its decision making.
KurtosisA measure of how peaked a return distribution is and how fat its tails are. The workbook takes a normal distribution as kurtosis 3; above 3 (leptokurtic) signals outliers and higher risk.
Lending portfolioAny mix of the risk-free asset and the market portfolio that uses only the investor's own money — it plots on the Capital Market Line between the risk-free rate and M, and lending means buying the risk-free asset.
LeptokurticA return distribution with kurtosis above 3 (excess kurtosis above zero): values bunch near the mean or sit far from it — a high peak with fat tails, which the workbook reads as riskier.
Leverage riskThe risk that borrowing or derivative positions magnify a fund's losses — which is why SEBI caps Category III leverage at two times NAV and permits Category I and II almost none.
Liquidity riskThe risk of being unable to get out of a position at or near the quoted price — because the contract is bilateral, because the order book is thin, or because volumes dry up near expiry.
Market ProxyA practical stand-in for the theoretical market portfolio — usually a broad-based equity index. The choice matters: an incorrect proxy distorts beta and the security market line.
Market riskThe risk of loss from movements in market prices — one named category in a manager's risk framework, alongside credit, liquidity and operational risk, and the one measured with VaR and stress tests.
Market Risk PremiumThe excess return a benchmark index earns over the risk-free rate — the "Rm − Rf" term in the CAPM formula used to compute a Category III AIF's expected return and alpha.
Maximum DrawdownThe largest peak-to-trough fall in a Category III AIF's AUM over a reporting period, quoted as a percentage of the peak — the worst loss an investor could have suffered in that window.
Mental accountingA cognitive error in which people treat equal sums of money differently depending on where they came from or what they are earmarked for, instead of treating all money as interchangeable.
Modified Internal Rate of ReturnA variant of IRR that discounts a fund's capital calls and compounds its distributions at the investor's opportunity cost, instead of assuming every cash flow earns the IRR itself.
Multiple on Invested CapitalA private equity performance multiple: realised plus unrealised value divided by total invested capital. Once every capital call has been met, it equals the fund's TVPI.
Negative real returnA return that looks positive on the statement but sits below the inflation rate, so the money buys less than it did before — the case the workbook flags when it says a real rate can be negative.
Net IRRAn AIF's IRR measured at the investor level, after management fees, incentive fees, fund expenses and taxes — always below the fund's Gross IRR, sometimes far below.
Nominal returnThe stated rate of return quoted on an investment before adjusting for inflation — as opposed to the workbook's real rate of return, which accounts for it.
Nominal Risk-free RateThe return on an investment whose amount and timing are certain, before adjusting for inflation: the real risk-free rate plus compensation for expected inflation.
NudgeA small, low-cost change in how a choice is presented — not a mandate or a financial incentive — that steers investors toward a better decision by working with a behavioural bias instead of against it.
Opportunity CostThe benefit given up on the next-best alternative when money is committed to one investment instead of another — the yardstick an AIF return has to beat before it counts as a good return.
OutliersExtreme returns in a fund's track record, whether highly positive or highly negative — the thing skewness and kurtosis are computed to detect.
Overconfidence biasAn emotional bias in which people place unwarranted faith in their own judgement and abilities — leading to underestimated risk, concentrated portfolios and excessive trading.
Percentage returnReturn expressed as a percentage of the amount invested rather than in rupees, which puts every investment on a base of Rs 100 and makes holdings of different sizes comparable.
PlatykurticA return distribution with kurtosis below 3, so excess kurtosis is negative: values cluster at consistent frequencies around the mean with no significant deviations.
Political riskThe volatility of returns caused by the possibility of a major change in the political or economic environment of a country — the reason investors in unstable systems add a country risk premium.
Portfolio betaThe weighted average of the betas of the holdings in a portfolio — the measure of its systematic, non-diversifiable risk used in CAPM, the Treynor ratio and market-neutral strategies.
Price Return IndexThe variant of a market index that captures only the price movement — the capital gains — of its constituents, leaving out dividends and interest. Mutual funds were benchmarked to it until 1 February 2018.
Probability distribution of expected returnsThe list of returns an investment might deliver, each with the chance of it happening — the form in which Modern Portfolio Theory assumes an investor sees every investment choice.
Prospect theoryKahneman and Tversky's 1979 theory of choice under risk: outcomes are judged as gains or losses from a reference point, and losses hurt more than equal gains please.
Random Walk HypothesisThe early form of the efficient market model: security price changes occur randomly, so successive one-period returns are independent and identically distributed.
Realisation RiskThe risk that the environment for exiting an investment changes for the worse before the fund is ready to sell — one of the specific risk categories SEBI requires an AIF to report on at fund and investee company level.
Real rate of returnThe return on an investment after the effect of inflation has been removed — what the money actually buys more of, as against the nominal percentage the product advertises.
Real Risk-free RateThe basic return an investor demands purely for postponing consumption, assuming no inflation and no uncertainty about future cash flows — the pure time value of money.
Regression of beta toward the meanAn empirical finding in the tests of CAPM: high-beta portfolios tend to drift down towards 1.00 over time, and low-beta portfolios tend to drift up towards 1.00.
Regular incomeOne of the two ways an investment pays you: a steady flow of money while you hold it, such as dividends on shares and fixed interest on debt. The other way is capital appreciation.
Regulatory RiskThe risk that laws and regulations change unfavourably — raising costs or altering competition — and hurt investment returns. The workbook treats it as a part of legal risk.
Reinvestment riskThe risk that the coupons or other intermediate cash flows from an investment have to be put back to work at a lower rate than the original investment earned, pulling the total return below the promised yield.
Required Rate of ReturnThe minimum return an investor expects before committing money: the nominal risk-free rate plus a risk premium. It is not a guaranteed, forecast or realised return.
Residual Value to Paid-in CapitalThe unrealised multiple: the estimated fair value of a fund's unsold investments divided by paid-in capital. It dominates early in a fund's life and falls to zero once every investment is exited.
ReturnThe reward for postponing consumption — the difference between what an investor gives up today and the larger amount received later, measured in several ways depending on the purpose.
RiskThe possibility that actual returns turn out different from what was expected — measured as the dispersion of returns around their own average, and not the same thing as uncertainty.
Risk adjusted returnThe return an investment earns for each unit of risk it takes on, rather than the return looked at on its own — in this paper, measured through the Sharpe ratio.
Risk appetiteAn investor's ability to take risk — one of four inputs, alongside age, financial situation and investment horizon, that the booklet says should shape how a person invests.
Risk averse investorAn investor who accepts risk only when paid a positive expected risk premium for it, and who demands a larger premium the greater the risk.
Risk Aversion IndexThe 'A' in the Markowitz utility formula U = E(r) − 0.5 × A × σ² — a number capturing how heavily an individual investor's utility is penalised for taking on variance.
Risk-free AssetAn asset whose return is certain: zero standard deviation, zero correlation with every risky asset, earning the risk-free rate and plotting on the vertical axis of a risk-return graph.
Risk managementThe general practice of protecting yourself financially against loss — insurance is one tool for it, and spreading your investments is another.
Risk neutral investorAn investor who judges an investment only by its expected return and applies no penalty at all for risk, so the certainty equivalent rate equals the expected return on the risky portfolio.
Risk premiumThe extra return an investor demands over the nominal risk-free rate as compensation for uncertainty about future cash flows — the last and largest block in the required rate of return.
Risk seeking investorAn investor who will engage in a fair game — one with zero risk premium — because he makes an upward adjustment to utility for risk, where a risk averse investor makes a downward one.
Rolling returnsThe average annualised return over many consecutive holding periods inside an evaluation period — say every one-year return in three years — used to remove the distortion of an unusually high or low start or end point.
SafetyOne of the three pillars of investment — how well protected your invested money and its return are, and how likely you are to get it back when promised.
Sector-specific riskThe risk tied to one industry, distinct from broad market risk. It is unsystematic, so it can be reduced by holding securities from other, unrelated sectors.
Security Market LineThe graph of CAPM: expected return plotted against beta. In equilibrium every asset lies on it — a security plotting above is undervalued, one plotting below is overvalued.
Selection riskThe risk that a fund manager's choice of securities underperforms the market or benchmark — present in an actively managed fund, and absent in a passive fund since the index itself decides the portfolio.
Self-attribution biasThe tendency to credit one's own skill for investment successes while blaming bad luck or others for failures — a bias that intensifies overconfidence and filters out information that contradicts it.
Semi varianceA downside-risk measure that looks only at the dispersion of returns below the mean (or a target return), ignoring the upside swings that standard deviation counts equally alongside the downside ones.
Sequence-of-returns riskThe risk that a portfolio making regular withdrawals is permanently damaged by poor returns arriving early in retirement, even if the average return over the full period is exactly as planned.
Sharpe ratioReturn earned above the risk-free rate divided by standard deviation — how much reward an investment produced for each unit of total risk its holder had to live with.
Simple interestInterest earned only on the amount you first put in (the principal). The interest is not added back, so it never earns interest of its own, unlike compound interest.
Simple returnThe plain percentage change in the value of an investment over a period — (ending value minus beginning value) divided by beginning value — with no adjustment for time or compounding.
Since-inception IRRThe internal rate of return computed from every cash inflow and outflow since a Category III AIF's launch date up to the reporting date — how a live fund's cumulative performance is reported to SEBI.
Single-factor modelThe workbook's own term for CAPM: a model that explains an asset's return using just one risk factor, market risk, unlike the several factors used in APT and other multifactor models.
Size AnomalyThe finding that small firms, measured by total market value, have consistently earned larger risk-adjusted returns than large firms — contradicting market efficiency.
SkewnessA measure of how far a fund's return distribution departs from symmetry around its mean. Zero is symmetrical; positive has a long right tail; negative has a long left tail and is riskier.
Standard deviationA measure of how far returns typically stray from their own average — the standard statistic for total risk, counting company-specific and market-wide causes alike.
Standard financeThe traditional view of finance built on rational, self-interested investors with full information — the baseline set of assumptions that behavioural finance was developed to challenge.
Status quo biasAn emotional bias in which a person, fearing regret, ends up taking no decision at all and keeps things as they are — closely linked to regret aversion.
Stereotyping biasAn emotional bias in which investors judge an investment by a general, surface-level impression instead of its actual merits — such as assuming a high-profile manager guarantees a well-run company.
Stock turnover ratioA liquidity measure for a stock: the number of shares traded during a period divided by the number of free-float shares outstanding, usually taken over one year.
Strategy RiskThe risk that an investee company changes, or drifts away from, the business strategy the AIF invested behind — one of the risk categories SEBI requires an AIF to disclose annually at investee company level.
Systematic riskThe part of an investment's risk that comes from economy-wide forces moving every asset at once — it cannot be diversified away, and it is the only risk the market pays you to carry.
Tax-adjusted returnThe return an investor actually keeps after tax is deducted — the figure that tells them what income is really available to spend, unlike the pre-tax rate quoted on the product.
Time diversificationReducing the risk of an equity investment by holding it across many time periods rather than across many securities, on the belief that bad periods are cancelled out by good ones.
Total returnThe whole return on an investment for a period: periodic income such as interest, dividend or rent plus the gain or loss in the value of the investment itself.
Total Return IndexThe variant of a market index that adds the dividends and interest paid by its constituents to their price movement — the only variant a mutual fund scheme may be benchmarked against since 1 February 2018.
Total Value to Paid-in CapitalA fund's investment multiple: cumulative distributions plus the residual value of unsold investments, divided by paid-in capital — equivalently, DPI plus RVPI.
Transactional riskThe risk that the other party in a share trade fails to pay for shares bought or fails to deliver shares sold, mitigated by trading through the exchange's guaranteed settlement system.
Treynor ratioRisk premium per unit of market risk — the return a scheme earned above the risk-free rate, divided by its beta rather than by its standard deviation.
Two-tier benchmarkSEBI's structure giving certain mutual fund schemes two benchmarks: a Tier-1 index standing for the scheme's category, and a Tier-2 index standing for the fund manager's style or strategy within that category.
UnderhedgingHolding fewer futures than the exposure needs — the specific failure of a duration-based hedge in a large yield move, because duration draws a straight line through a curved relationship.
Undervalued securityUnder CAPM, a security whose estimated return plots above the Security Market Line — earning more than its systematic risk (beta) warrants under market equilibrium.
Unsystematic riskThe part of an investment's risk that belongs to one company or one issuer — a strike, a fraud, a downgrade — and which diversification can remove, unlike market-wide systematic risk.
Utility scoreA single number that scores an investment for one particular investor: expected return minus a penalty for risk, scaled by that investor's own risk aversion.
Value AnomalyThe finding that stocks with a high book value-to-price ratio have earned superior risk-adjusted returns — an anomaly against the EMH that underpins value investing.
Value at RiskA statistical estimate of the most a position is likely to lose over a set holding period at a chosen confidence level — the idea behind the initial margin a clearing corporation charges on a derivatives trade.
VarianceA measure of how widely a scheme's periodic returns fluctuate around its own average return — the square of standard deviation, and a risk measure relevant to both debt and equity schemes.
Variance of a SecurityThe probability-weighted average of the squared gaps between a security's possible returns and its expected return — the forward-looking measure of a single asset's risk in Modern Portfolio Theory.
Vintage YearThe year in which a fund first delivers investment capital — the marker used to compare private funds that started investing at the same point in the economic cycle.
Volatility riskThe risk that a company's share price swings up and down over time, even when the company itself is not in danger of failing. One of the seven risks in the booklet.