Risk and Return Analysis
Risk and Return Analysis
In the financial context, the risk is a common terminology that refers to the possibility of losing the invested amounted. Therefore, risk is the uncertainty that a specific investment will not achieve its expected rate of return. It is imperative to note that risk and return are different from loss and gain. Naturally, individual investors assume that risk as the likelihood that they could realize losses in their investments. Most people prefer investment returns that surpass the expected targets. However, since risky assets also produce adverse outcomes, it is possible to conclude that bigger uncertainty increases the likelihood of an investment generating larger gains, as well as larger losses.
Relationship between Risk and Return
The relationship between risk and return is typically referred to as the risk-return tradeoff. The risk-return tradeoff is the rule that prospective returns increase with a rise in risk. Low-risk investments having low uncertainty are linked to minimal possible returns. The direct relationship between risk and return argues that if an investor takes on a higher risk investment, he is rewarded with greater returns. Conversely, high levels of uncertainty that can be categorized as high-risk investments are connected to high returns. Based on the risk-return tradeoff principle, invested funds can generate higher profits as long as it is subjected to the likelihood of being lost (Connor, Goldberg, and Korajczyk 67). However, there is a negative relationship between risk and return. In certain cases, an investor can increase the amount of investment and by default, the risk, and fail to realize an increase in return. This can mainly be because of the nature of the project that makes it pointless to increase the amount of investment. The last form of relationship between risk and return is low risk-high return. In certain projects, investing a low amount can yield high returns. Such low-risk investments include government bonds that have a guaranteed high rate of return because the state can print more money or borrow elsewhere (Connor et al. 34). Maintaining a balance between risk and return is a challenge for most investors. However, equipped with the correct information, an individual can take full advantage of their returns depending on the level of risks that an individual can handle. Each investor has to establish the amount of investment risk that is suitable for them in terms of lifestyle, financial security, and risk tolerance. Creating equilibrium between risk tolerance and the other elements is imperative. A minuscule percentage of wealthy people and those who have an excellent pension can afford to maintain all of their assets in CDs or treasury bonds (Leibowitz, Bova, and Hammond 87). The rest of the people will have to learn how to take on more risk. Having an experience with investment risks is the initial step toward creating the perfect balance for a unique portfolio.
Highest Risk: Bonds or Common Stocks
A bond can be defined as an investment, which comes in the form of a debt extended to a company or a government. The borrower typically borrows the funds at a fixed interest rate and a fixed period. The main reason for placing a bond is to gather funds for a specific project or activity. In the comparison between bonds and stocks, it is important to factor in the previous principle of high returns on high-risk investments (Falkenstein 43). Secure investments are attached with a low-risk tag. However, the returns are similarly lower. Bonds and ordinary stocks each have their own set of risks. However, corporate or high-yield bonds frequently possess the lowest level of risk compared to stocks. However, the downside is that they have significantly lower returns, regardless of regular dividend payments. Conversely, ordinary stocks possess the highest risks compared to bonds as well as the biggest returns (Falkenstein 21).
A significant difference when considering the returns of stocks against bonds is that stocks theoretically possess a limitless potential for an increase in return percentage. In other words, there is no ceiling or limit on the ultimate value of the stock after a certain period. Conversely, an individual investing in bonds is normally aware of the upper limit that can be realized on such a venture, particularly if the investment is preserved to maturity. It is accurate that a bond can be sold for a fair price before its maturity date. Hoverer, it is true that the prospects for appreciation are closely restricted when compared to stocks (Falkenstein 56). Since stocks can appreciate infinitely, there is a definite risk that the price can also drop sharply. This has the effect of making the stock invaluable and therefore, categorized as a loss. Both investment vehicles possess other risks as well. The major types of risks that affect bonds include credit risk, inflation, and fluctuating interest rate. Credit risk is a significant issue that emerges when the issuer lacks the ability to service its payments on schedule and eventually, defaulting on the bonds. Therefore, while both bonds and stocks are risky, bonds are less risky since they are guaranteed investments. Stocks have a bottom price that implies that the investor made a complete loss.
Significance of Understanding Risk and Return in Business Ventures
One of the key benefits towards understanding risk and return in business ventures is that it improves the investment skills of the individual. The ordinary investor is unaware of the risk-return tradeoff principle and other associated factors such as the risk levels. Examining this topic exposes individuals to greater information that can be used to accomplish successful investments. For instance, understanding the level of risk in choosing bonds or stocks will assist an individual in choosing the best investment vehicle. The risk and return analysis also assist in understanding one’s character particularly their ability to handle financial risk. The analysis was also important in revealing information on the definitions of different investment vehicles. Understanding how stocks, bonds, and other investment instruments work within the economy can guide financial decisions for people in different stages of life. Lastly, understanding the relationship between risk and reward will assist professionals in the finance sector to make decisions on behalf of their clients.
In conclusion, it is important to reiterate the different types of relationships between risk and returns. An individual who is risk averse should definitely be prepared to receive very low returns on their investments. Conversely, individuals who take greater risks have a bigger likelihood of enjoying higher returns. The amount of risk that a person can take is completely dependent on their ability to handle risk. The ability of an individual is dependent on personal factors, for instance, the investment objectives, the time allocated for the investment to mature, and the amount one is comfortable with losing.
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Connor, Gregory, Lisa R. Goldberg, and Robert A. Korajczyk. Portfolio Risk Analysis. Princeton: Princeton University Press, 2010. Print.
Falkenstein, Eric. Finding Alpha: The Search for Alpha When Risk and Return Break Down. , 2009. Print.
Leibowitz, Martin L, Anthony Bova, and P B. Hammond. The Endowment Model of Investing: Return, Risk, and Diversification. Hoboken, N.J: John Wiley & Sons, 2010. Print.
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