Risk and return - Essay Example

Risk and return are two inversely correlated concepts. A person or a corporation that is risk adverse will not take chances. Lower risk lead to lower returns and higher risk leads to higher returns. The general rule of higher risk leading to higher returns is not set in stone. One of the problems with higher risk is that it can lead to financial catastrophes. For example imagine a person that invests in a penny stock. Penny stocks are considered the most risky of all types of investments. The person decided to invest in penny stock X because he wanted the possibility of earning a higher return. Due to the risk associated with penny stocks the stock ended up defaulting due to the fact that the company went out of business. In this particular case instead of obtaining a higher return the investor ended up losing all his money. 2. Return on investment can be defined as a performance measure used to evaluate the efficiency or to compare the efficiency of a number of different investments (Investopedia, 2011). The formula to calculate return on investment is (Gain from investment –cost of investment) / cost of investment. Companies are always looking to maximize their return on investment. Corporations able to obtain above normal returns on investment are more profitable than the competition. Return on investment can be manipulated when determining projects by changing the expected return of the company. For example a company may establish new financial policy of only accepting projects that achieve a return on investment of 10%. The old policy of the company was accepting project with a minimum investment of 15%. The new policy will enable the company to accept new projects that may have been rejected in the past with the old policy. Investopedia.com (2011). Return on Investment - ROI. Retrieved March 17, 2011 from http://www.investopedia.com/terms/r/returnoninvestment.asp 3. I once worked on a project that had a huge potential return on investment. The project cost was about $100,000, but the project had the potential to achieve a return on investment that surpassed one million dollars. The project was fully funded and completed, but in the end the introduction of the new product failed to achieve the expected sales. The company was able to recover the majority of its investment even though the firm suffered from losses. The firm lost approximately $15,000 from this project. To me this experienced proved that higher risk can lead to operating losses. 4. The concept of higher risk leading to higher profits is real and in my personal experience it has paid off dividend. When I took my first finance course the professor gave the class a stock market simulation project. I like the project so much that I decided to turn the project into a reality. I opened up an investment account with Scottrade. I invested $2000 to build up a portfolio of stocks. The portfolio was composed of about six stocks including several blue chip stocks and a penny stock. The penny stock was VTSS. I invested about $350 in the VTSS penny stock. After two months the penny stock when up from $0.35 to over $1.50 cents. I made over $1000 dollars from the purchase of the stock. When the class ended I decided to cash out my portfolio. I utilized the earnings from my portfolio to purchase a 1994 Eclipse automobile for my sister. 5. In the corporate world companies have to take risk in order to obtain a return. A risk that a lot of multinational companies are faced with is the decision to penetrate new marketplaces. There are regions in the world that are susceptible to huge risk such as the Middle East. In the Middle East the risks associated with terrorism are very high especially for American companies. Taking chances is a part of the business process. Even when a company has a successful product line the constant changes in the marketplace forces companies to take risk such as introducing new products into the marketplace 6. People take risk in their regular everyday life without even realizing they are doing it. For example a person might decide while driving to take a different route in order to save time. If the person gets into traffic jam due to the fact that the individual took a new route, the risk the person took did not pay off. In the business world the risk factor is a variable that has to be considered by managers when making decisions. Corporations that never take risks will never be able to maximize shareholder’s wealth. 7. When a company has several alternatives for ventures to choose from the managers have to evaluate the risk associated with each project to decide whether or not to accept the project. A financial technique that can be very useful to evaluate projects is net present value (NPV). A project should only be accepted if its net present value is above cero. The level of risk the project has determines how profitable it may be. Higher risks lead to higher returns. 8. Personally I am a person that likes to take risk. Due to the fact that risk and return are associated one must always evaluate the tradeoff between the two concepts. I have gotten lucky in the past in the stock market with high risk penny stocks. This does not mean that if I continued to invest in penny stocks that I would have the same luck. As a future manager I plan to pay a close attention to the concept of risk in the workplace. Good managers evaluate the risk associated with their decisions carefully prior to deciding in a course of action. 9. Investing in new equipment and machinery involves a certain level of risk. Imagine a company that decides to upgrade their equipment by investing $250,000. In theory the new investment would lower the labor costs by 20%. The manager determined based on that metric that the firm would be able to recover its investment within one year due to the labor savings. The manager took a risk, but he miscalculated the labor savings and in reality the new machinery was able to reduce to labor savings by 5%. Now instead of taking one year it would take four years to recover the investment. 10. Companies that are effective at taking calculated risk have a higher chance at maximizing shareholder’s wealth than companies that are risk adverse. In the business world risk is a reality that must be well managed by the executive managerial staff. Back in the 1990’s Nike decided to invest in developing countries to lower their operating cost. The problem was that the corporation took too many risks as far as not investing sufficient money to have control protocols in place. Their foreign locations ended up becoming sweetshops. The firm lost millions of dollars in sales from the public relation fallout that followed due to bad risk the managers took. Read More