Inflation refers to a continuous rise in general price level, which shrinks the value of money or purchasing power over a certain length of time. It is calculated in terms of per cent change in the value of price index consisting of a range of goods or services. An inflation rate of 8% means that the general level of prices of goods and services has increased by 8% over the previous period.
In other words, purchasing the same amount of goods and services will cost you 8% more than what it would have cost you in the previous period. Thus, Inflation can also be explained as a decline in the real value of money – a loss of purchasing power in the means of exchange, which is also the monetary unit of account.
There are several inflation measures available in India – the most commonly used are based on Consumer Price Index (CPI) and Wholesale Price Index (WPI). Within these, there are several sub-indices (e.g. CPI for Industrial Workers, CPI for Urban Non Manual Labourers, etc.) as well. These sub-indices are designed to see how price increases affect different set of people. Since WPI is available on a weekly basis, inflation based on that is the most commonly referred inflation measure in India.
Risk is defined as the uncertainty or deviation in the return expected from an asset class. This risk could be measured in terms of standard deviation of an asset class. Risk can be classified as below:
A security's return is calculated by its holding-period return: the change in price plus any income received, expressed as a percentage of the original price. An improved measure would be to take into consideration the timing of dividends or other payments, and the rates at which they are reinvested. The total return on an investment has two components: the expected return and the unexpected return. The unexpected return comes about because of unanticipated events. The risk from investing stems from the possibility of an unexpected event.
Relationship between risk and return
An asset class is a specific category of investment such as stocks, bonds, real estate or cash. Investing is a trade-off between risk and expected return. Depending on the risk appetite of an individual, he can choose to invest in a combination of asset classes that would optimize his returns. Some of the most common asset classes are as follows:
Diversification indicates building/ creating an investment portfolio that includes securities from different asset classes. It spreads risks across various financial investments, reducing the impact that poor returns from any one investment are likely to have on the overall portfolio. The prices of shares, bonds, listed property and other investments often do not rise and fall in tandem. When one type of investment is on the rise, another may be on the decline. The result is that your portfolio’s overall performance is likely to be less volatile. The objective of diversification is to reduce the risk involved in building a portfolio. Diversification reduces the risk for an investor because all investments may not move in the same direction in the same proportion at the same time.
A diversified portfolio should be constructed to reflect your personal goals and individual risk tolerance. There are many ways to diversify across several asset classes. Asset allocation is a method of strategically dividing your investment portfolio among stock, bond and cash investments to help protect your portfolio from the rise and fall in any one investment.
Diversification will help to:
- Ease potential risk to overall portfolio
- Improve chances for attaining consistent returns
- Avoid the downside that can come from regularly readjusting your portfolio to follow current market developments