You know that high-risk investments give high returns and turn-about. The study of human behaviour reveals that people prefer less risk against more risk for a known level of return. The higher the risk in an investment, the higher the returns. It also attracts more investors.
The presence of risk in any investment opportunity does not mean that you should not opt for it. You should identify the degree of risk you can tolerate in an investment plan against an expected return. With a proper understanding of the risk and return relationship, you can achieve any financial objective and make better investment decisions.
Idea of Risk and Return
You should know that some investments are riskier than others and present a great risk of loss. Thus, learning the relationship between risk and return is vital before considering investing in any scheme. A suitable mix of risk and return will help you achieve your financial objectives.
Some people prefer a low-risk, stable income stream, while others don’t shy from taking a risk for greater returns. The relationship between risk and return is directly proportional. With high risk, you can get high returns and vice versa, but sometimes this equation may not work due to financial issues. Investment companies cannot profit due to debt to investors. In such cases, investors may lose their investment in the bankrupted company.
The relation between the threats and rewards of investment is called the risk and return tradeoff. Low-level risks are linked with potentially low returns and greater levels of risk with greater returns. The risk and return tradeoff determine whether the invested money will offer greater profit or loss.
Types of Risk
The measure of risk varies with its type. Risks can be differentiated into various criteria—reinvestment risk, foreign exchange risk, country risk, political risk, credit risk, market risk, etc.
Based on occurrence, risks can be further of two types, speculative and pure. The outcome of pure risk is either neutral, with no loss, or adverse, with loss. On the other hand, speculative risk indicates uncertainty about the profit or loss of investment.
Based on flexibility, the risk is either dynamic, affected by fluctuations in the economy, or static, which is not affected by the fluctuations in the economy. The dynamic risk impacts a large population to different degrees.
Based on the measurement, risks are of two types, financial and non-financial. The risks that can be measured in terms of money are called financial risks, while those that cannot be measured in terms of money are called non-financial risks.
Subjective and objective risks are types of risk based on behaviour. Subjective risk is the psychological doubt of the investor about uncertainty, while the objective risk is a precise variation of the risk concerning investments.
Based on coverage, risks can be real or particular. Real risk affects a larger population or all market sectors, while the particular risk is associated with a particular firm or industry. Lastly, based on diversification, the two types of risk are diversified and non-diversified.
Apart from the risks mentioned above, some other risks are inflation of rate, market risk, fluctuation of interest rates, financial risk, and business risk. The knowledge of types of risk helps better identify risks and returns.
Types of Returns
There are different methods to compute investment returns. The first is the simple average method based on probability and geometric mean. Measuring risk is an essential aspect to determine the profit from an investment. These methods help to calculate different types of returns.
Relationship between Risks and Returns
There is a positive relationship between risk and return. Greater risks do not guarantee higher returns; they can also result in the loss of the invested amount. To yield the positive effect of the risk and return relationship, you must figure out your risk tolerance.
Risk tolerance can vary based on different factors. The significant factors that impact risk tolerance are the capability of the investor to replace the lost fund in the future and their retirement time. They directly impact the future earning probability. Some other factors that affect risk tolerance are the investor’s assets like insurance, pension plan, home, and portfolio size.
The relationship between risk and return in finance is simple to understand if you know your risk tolerance level and can estimate the benefit or loss from returns. Exploring the different aspects of risk according to the stature and capacity of the subject can benefit the investors from facing any unexpected events in exchange for returns. The subject can benefit investors by exploring the meaning of risk according to their stature and capacity to face unexpected events in exchange for returns.
Conclusion
Investors need to understand the risk and return relationship before spending on any type of security. Any investment with high returns also poses an increased risk. Investors should understand their degree of risk tolerance before selecting any investment scheme with an expected return. With proper knowledge of the risk and return relationship, people can attain their financial objectives easily and make better investments. Investors should also be familiar with different types of risks and the degree of their association with investment schemes.
