Risk and returns are investment terms that are directly proportional to one another. The correlation is very direct and such that an increase in the potential for returns for a certain investment usually comes with higher risks. Also, since there is no shortage of risk in the investment market, we can safely conclude that there is no shortage of returns either. This article contains everything you need to know about risk and returns pertaining to investment.
What is the concept of risk and return?
The concept of risk and return exists in direct proportion to one another. More accurately, we represent the return on investment as a percent and assumed to take any value within a specified range. Also, risks and returns are affected by several factors on the market. Therefore, it is why experts encourage diversification of investment portfolios, although it limits potential returns. Regarding investment approach, we often prioritize the reduction of risk over the limiting of potential returns.
Painting a more vivid image, a person making an investment does so to get returns sometime in the future. However, the future is unpredictable and it can’t guarantee any fixed return. This is what is referred to as risk. Risk is the variation in expected returns from an investment; it is simply the tendency that you are not going to get the returns you expect.
Why are risk and return important?
The risk and return relationship are very important due to the important role they play in decision making before investment. Also, there is a positive correlation between the amount of risk and the extent of potential returns. In addition, they are important due to the role they play in determining the diversification of investments. Normally, investments with similar risks level are usually placed together in a single portfolio. This is so as to maximize returns and keep the possibility of volatility to the bare minimum.
What is risk return trade off?
This is simply the correlation between the risks one runs when investing, matched with the actual performance of the investment itself. Furthermore, the rule states that the higher the risk, the higher the reward and Vis a Vis. Therefore, the risk-return trade-off simply explains the concept of risk and return. Also, it implies that an investor can only earn higher profits (returns) if he chooses to accept a higher possibility of loss.
What is risk tolerance?
This is simply refers to the extent to which an investor is willing to accommodate a risk in relation to his investment. Also, we take the following factors into consideration in estimating risk tolerance:
- The size of the portfolio
- Possible future earnings potential
- The amount of time left till retirement
- Capacity to replace lost funds
- The types of assets available
How do you calculate risk and return?
Calculating risk return is very easy. It is done by taking the return of the investment and subtracting the risk-free rate from it. You then divide your result by the standard deviation of the investment. Also, note that when it comes to risk and return, a higher Sharpe ratio is always better, except if they are both equal.
Before embarking on an investment journey, it is important that you carefully access its risk and return possibility. Also, depending on your risk tolerance, you can choose to go for a high-risk investment due to its high return potential. However, note that the loss associated with these kinds of investment are mostly catastrophic.