Risk and Return - Econlib (2024)

FAQs

How do you calculate risk and return? ›

When you're an individual trader in the stock market, one of the few safety devices you have is the risk-reward calculation. The actual calculation to determine risk vs. reward is very easy. You simply divide your net profit (the reward) by the price of your maximum risk.

The greater the risk that an investment may lose money, the greater its potential for providing a substantial return. By the same token, the smaller the risk an investment poses, the smaller the potential return it will provide.

Relationship between risk and returns

Generally, the higher the level of investment risk, the higher the potential return and the greater danger of things going wrong.

Risk-return tradeoff states that the potential return rises with an increase in risk. Using this principle, individuals associate low levels of uncertainty with low potential returns, and high levels of uncertainty or risk with high potential returns.

Risk is the chance that you might lose money, while return is the money you make from your investment, and usually, investments with higher risk have the chance for higher returns.

Risk is the combination of the probability of an event and its consequence. In general, this can be explained as: Risk = Likelihood × Impact.

Rule one: Risk and return go hand-in-hand. Higher returns mean greater risk, while lower returns promise greater safety.

Low-risk, low-return investments: Treasury bills are an example of this type of investment. They are issued by the government and are considered very low-risk, but they also offer lower returns compared to other investments. High-risk, high-return investments: Penny stocks are an example of this type of investment.

The capital asset pricing model (CAPM) describes the relationship between systematic risk, or the general perils of investing, and expected return for assets, particularly stocks. It is a finance model that establishes a linear relationship between the required return on an investment and risk.

In many cases, market strategists find the ideal risk/reward ratio for their investments to be approximately 1:3, or three units of expected return for every one unit of additional risk. Investors can manage risk/reward more directly through the use of stop-loss orders and derivatives such as put options.

What is the conclusion of risk and return? ›

Answer: The relationship between risk and return is directly proportional. Higher risks give higher returns and vice versa. But, sometimes, this equation may not work due to financial issues. Investment companies cannot profit due to debt to the investor.

Importance of risk return trade-off in mutual funds

Maximising returns: Investors can use the risk-return trade-off to maximise their returns. By taking calculated risks, investors may potentially earn higher returns on their investments.

A positive correlation exists between risk and return: the greater the risk, the higher the potential for profit or loss.

The risk and return trade off can be applied in real life situations such as buying a house. If you are going to buy a house and want little maintenance, you will have to pay a higher price because, since the risk is low, the expected return will be low as well.

What is a high-risk, high-return investment? High-risk investments may offer the chance of higher returns than other investments might produce, but they put your money at higher risk. This means that if things go well, high-risk investments can produce high returns.

RRR = r_f + ß(r_m – r_f)

Where: RRR – required rate of return. r_f – risk-free rate. ß – beta coefficient of an investment.

Risk management involves identifying and analyzing risk in an investment and deciding whether or not to accept that risk given the expected returns for the investment. Some common measurements of risk include standard deviation, Sharpe ratio, beta, value at risk (VaR), conditional value at risk (CVaR), and R-squared.

What is the expected return of the security using the CAPM formula? Let's break down the answer using the formula from above in the article: Expected return = Risk Free Rate + [Beta x Market Return Premium] Expected return = 2.5% + [1.25 x 7.5%]

Total Risk = Market Risk + Diversifiable Risk. The total risk of a security portfolio can be divided into systematic and unsystematic risk; systematic risk is the risk that cannot be avoided by any means; it is the inherent risk of the portfolio, and also known as market risk.