What Is Risk And Return?
Risk and return in financial management is the risk associated with a certain investment and its returns. Usually, high-risk investments yield better financial returns, and low-risk investments yield lower returns. That is, the risk of a particular investment is directly related to the returns earned from it.
The risk and return analysis aim to help investors find the best investments. Hence, investors use many methods to analyze and evaluate the market, industry, and company. Diversification of the portfolio, i.e., choosing an optimal mix of different investment options, can reduce the risk and amplify returns.
Table of contents
- The concept of risk and return in finance is an analysis of the likelihood of challenges involved in investing while measuring the returns from the same investment.
- The underlying principle is that high-risk investments give better returns to investors and vice-versa. Hence, the price of the risk is reflected in the returns.
- Nevertheless, high-risk investments don’t always generate higher revenue. That is precisely the ‘high risk’ involved in investing. It’s a coin-tossing situation, and the investor should be prepared for both scenarios – profit and loss.
Risk And Return Explained
Financial risk and return in investing are perhaps the most crucial parameters considered by investors while choosing an investment option. Individuals who invest on a large scale analyze the risks involved in a particular investment and the returns it can yield. Let’s take a step-by-step approach to understand the concept.
First, let’s begin with risk. A risk can be defined as the uncertainty related to the investment, market, or company. Investors want profits, and the risks can potentially reduce the profits, sometimes even making a loss for them.
Many types of risk and return concept are involved in investments – market-specific, speculative, industrial, volatility, inflation, etc. However, studying the market thoroughly can help investors make the right decisions. They can analyze the trends and forecast the situation.
Now, let’s understand return on investment, or ROI. It can be explained as the financial gains from investing in a certain investment. Ideally, individuals prefer investments that give them higher returns, like stocks of Google, Amazon, etc.
The correlation between financial risk and return is fairly simple to comprehend. The risk in choosing a certain investment is directly proportional to the returns. Therefore, selecting a high-risk investment can give higher profits, while a low-risk investment will minimize the returns.
So, plotting a graph between the risk and return on investment will give a straight line passing through the center.
Risk And Return Of A Portfolio
One of the ideal measures to reduce risk while simultaneously maximizing revenue is by diversifying the investment portfolio. Investors can choose multiple investments that offer different returns accordingly.
There are different investment options: stocks, bonds, commodities, mutual funds, etc. Stocks usually carry high chance of failure but can give good returns. On the other hand, government bonds can carry low to zero risk but offer low profits.
There are many benefits of diversifying an investment portfolio. Investors can choose to invest in stocks with high risk and compensate for the risk by investing in bonds. Bonds usually give assured returns, although it is low. They can also invest in mutual funds for a longer period with moderate risk.
In studying the risk and return concept, some financial experts suggest investing in different industries or markets. Because different sectors prosper and fall at different times. For example, during the onset of the COVID-19 pandemic, many internet and e-commerce companies flourished, whereas automobile companies didn’t do well. So, taking different investment stands can help investors in the long run.
The risk and return analysis is an important concept in the financial market. Both pf them can be categorized as follows:
Types Of Risk
- Market risk – It is also called systematic risk and arise due to various market related factors like economic and political problems, interest rate and currency fluctuations, etc. They have a huge impact on the investors.
- Specific risks – They are related mostly to company itself. They may be controlled through diversification an monitoring.
- Credit risk – This is related to credit worthiness of the company or business. If the financial condition of the business is good, it will be able to meet its current and future obligations and repay its debts on time. This will lead to good credit rating. Credit risk is the result of deteriorating financial health of the company.
- Liquidity risk – This is the result of the business not being able to earn good revenue to meet its financial obligations and maintain high working capital.
- Interest rate risk – The fluctuations in the interest rates in an economy can affect the business’s borrowing capacity.
- Inflation – The inflation leads to erosion of value of investments and the value of cash flows in future.
Types Of Return
- Capital gains – Any good investment will rise in value as time passes by. Thus the assets will be valued higher if they are sold later on as compared to its purchase price, giving capital gain.
- Dividends – they are a steady source of income for investors who invest in shares of companies giving regular dividends which are a part of the profits set aside for investors.
- Interest – Borrowers like individuals or corporates borrow money for meeting expenses or capital requirements. The lenders give the funds to get interest on the principal amount which is a return on investment for the lenders.
- Rental income – Any property rented out can earn rent on a regular basis, which is also a return in the real estate property.
- Return from currency trading – Profits earned from trading in exchange rates by using the differences is exchange rate of different currency is also a form of return for those who do currency trading.
Thus the above a some important types of risk and return on investment that are very popular in the financial market.
Here are a few examples of risk and return concept in investing.
Consider the example of Jane, who has been investing for many years. However, she wants to get maximum returns. She consults a money manager, John, for this purpose. John advises her to diversify her portfolio.
He suggests the following:
- Hold a FAANG stock.
- Invest in stocks ranging from $100 to $150 like Volkswagen or Walmart.
- Invest in U.S. Treasury bonds.
- Invest in mutual funds.
This would help her to get better returns and offset losses if any.
Let’s look at a recent example of risk and return analysis. Currently, most stock prices are falling, especially in the United States. Many are convinced that an economic recession accompanies this bear market. Therefore, many people are in a hurry to sell off their shares when they can still make profits, even if negligible.
However, the New York Times has published a new article that tells investors not to sell their stocks in a bear market. Instead, they should hold on to it. Even a cheap stock wouldn’t be a loss in the long run. The theory behind this is that investors will be able to buy low and sell high when the prices increase, which it eventually will. But this will work out only for those ready to invest long-term.
Also, it doesn’t mean buying and accumulating cheap stocks. Instead, investors should analyze the market and the company. If they decide to buy in a bear market, the stock should be promising in the long run. And, like any investment, this too requires a lot of planning.
Frequently Asked Questions (FAQs)
Financial risk and returns have a direct correlation. That is, high risk corresponds to increased returns and vice-versa. However, it is necessary to remember that the high risk can mean potential loss, and there might not be any revenue at all in some cases.
While investing, it is essential to evaluate the performance of the stocks, the company, and the market. Analysis helps the investor get better insights into the investments they find attractive. It includes evaluating the company’s financial performance by considering profits, EBITDA, etc., and analyzing the stock performance trends over the years.
This concept is necessary to optimize returns, rather than just investing randomly. This is because the main objective of investors is to make profits. Risk and ROI are the two important factors that affect profits, hence the importance of the concept.
This has been a guide to what is Risk And Return. We explain its relation to a portfolio along with examples, various types and its graph. You may learn more from the following articles –