How Risk and Return Interrelate - Literature review Example

Introduction A risk is the chance that the actual return from an investment does not meet the expectations. It incorporates the possibility that all or some of the original investment may be lost. Risks exists in different versions and it is normally calculated by working out the standard deviation of the historical returns of any investments or even the average returns of the same investments and when the standard deviation turns out to be high then the degree of the risk is also high (Stone). Risks are not healthy for any venture operations and as a result, many companies have resorted to invest vast sums of resources and time to establish risk management strategies. This has the impact of running all the way to helps in the of all the risks that closely relate to the business and investment dealings. It is worth noting that in the process of managing risks, the assessment of the said risks which revolves around determining the risks that surround any business environment or an investment by a company or individual (Needham). There are a lot of theorem that revolve around risk and return. It is said that always, the higher the risk one is willing to incur the higher the returns they are likely to get. Throughout the paper, we want to find out how risk and returns are related and all the aspects surrounding each situation. How Risk and Return interrelate While a risk is the chance of a loss, return on the other hand is the gains made or losses incurred of an investment security over a given period of time or duration. When considering returns it is important to look at both the income and the capital gains by an investment and returns are normally quoted as a percentage of the investments made ("Balancing Risk and Return.”). In finance, we are most concerned about the relationship that exists between risk and return. This is because the potential amount of return on any given form of investment depends on the degree of risk that any investor is willing to take. The higher the amount of risk that any investor is willing to take with their investment translates to the returns in equal measure. This is due to the reason that any investment is compensated to the tune of the risk it is willing to take (Needham). The Treasury bond, which is considered the safest, in fact risk free as compared to the corporate bond has a very low rate of return. This is because there is the risk that the corporation is more likely to go bankrupt as compared to the government hence the risk of investing in a corporate bond is higher which prompts the higher returns. Therefore, low levels of uncertainty or low risks are only associated with lower potential returns while in the case of high levels of uncertainty are associated with high potential returns ("Balancing Risk and Return.”).The risk-return tradeoff clearly shows us that any money subjected to investment will only posses the possibility of bringing profits only and only when they have the possibility of getting lost. When choosing any given investment portfolio and because of the risk-return tradeoff, an individual wanting to engage in such form of investment must be aware of their risk tolerance. The fact remains that the price of achieving returns involves at least taking on some risks hence to make money risk can never be avoided completely but to find a balance between risk and returns ("Balancing Risk and Return.”). The risk of an asset can be measured using any f the following techniques; Capital Asset Pricing Model of Sharpe and Lintner. As opposed to the earlier version, this measures risk by the covariance of the asset’s returns with return on all the invested wealth. As risk cannot exist alone, return on the other and depend on the extent to which any given investor is willing to take risk for their investment. For the sake of good decision making concerning saving and investing a thorough understanding of both risk and returns is of fundament given that risk and return are directly related. The greater it is to lose money in an investment; the grater is the potential of making as much money. Therefore, when making decisions, which concern an investment, the risks involved and the returns have to be balanced. First, a balance can be strike when a good decision is made on the investment to be made among the ones available. For example, when there is a less risky investment with an above average return, it would be wise to go for such and leave the one with high risk and greater returns. It is important to note that it takes time and effort to strike a balance between risks and returns hence a lot of patience is called for. There exists a range of risk management tools, which can also be used in striking a balance between risk, and return among which we also have common sense. Portfolio must also be adjusted together with diversification for the sake of the efficiency of the operations of the market. Without trying to simplify a highly complex issue, the tradeoff between risk and return is the most important way of determining an investment to the specific individual and getting such a balance right is critical (Needham). This is because too much risk would propel individuals to sell their security even in instances when the market is down resulting into losses for them. In efforts to striking, a balance between risks and investment another element of information that should be known is the duration upon which one is willing to make their investments. This is because it has been found out that investments with highest potentials of returns have vast fluctuations. This important information will help know the degree of risk one can take depending on whether they are long term investors are short-term investors. More stable investments are needed when the time horizons shorten hence as one ages they are advised to strike a good balance by ensuring that a greater percentage of their investments is on bonds given that they at that point cannot afford to engage in highly risky ventures (Needham). Risks come into a business or investment in many forms hence when talking about risk-return tradeoff, the primary mode to measure this risk is volatility or the degree upon which an investment is fluctuating in price. This is because different levels of price fluctuations are experienced with different categories of assets hence different risk-return balance levels. One cannot fix this ratio at the same figure for stocks whose prices swing often to those of bonds whose prices tend to be less dramatic (Needham). Yes, I do agree. Some investors prefer invest some project with high risk, because they believe they would get high return. It is true that investment which have very high risks tend to bring a lot more returns that those with very low risks. For example, A Certificate of Deposit (CD) or a savings account is considered low risk, low return investment.  If you put your money in one CD, there will be a low rate of return in form of interest paid to you. Though you will be gaining money on the investment, it will not be that much. Stocks on the other hand are called high-risk high return investments due to the nature of enormous expenditure without necessarily knowing the returns (Needham). If the investment goes well though, one ends up getting much more in terms of the payout depending on the value of investment done by someone. Any investor hence has the freedom of making calculated decisions when it comes to the nature of investments that they are willing to venture into given that this will influence what they earn depending on the degree of risk that they are willing to take. In efforts to try make high returns for ones business as a result of risking high risks, the investor must understand their preference for return verses the risks they intend to incur to achieve it which goes along the same line with the duration of the investment (Needham). In this process, the investor has to be advised on the available securities and that some like assets must never be included in the portfolio. Conclusion Every investor must deal with the trade-off between risk and return. Despite the numerous types of risk inherent in investing, investment advisers regard volatility as the primary indicator of risk. The trade-off between risk and return is the most important step in determining the most appropriate investment strategy most so in the event that an investor wants to make high-risk investments. Risk whether high or low is really about losing money rather than volatility, and therefore, investor’s time horizon matters to dictate the risk level and amount to invest. Over the medium term, risks and returns for asset classes can deviate markedly from long-term expectations to short term. Work Cited "Balancing Risk and Return." Bank Investment Consultant 14.4 (2006): 36-. ABI/INFORM Complete. Web. 23 Feb. 2013. Needham, Daniel. "The Importance of the Trade-Off between Risk & Return." In Finance 126.2 (2012): 27-.ABI/INFORM Complete. Web. 23 Feb. 2013. Read More