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Risk-Return Concepts - Essay Example

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For a potential investor, the market presents an array of financial instruments where money can be invested into. The primary motivating factor in choosing investment is the expected returns to be generated. However, it should be noted that the decision in selecting the "right" investment is also largely dependent on the investor's perceived risk…
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Risk-Return Concepts
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Risk-Return Concepts For a potential investor, the market presents an array of financial instruments where money can be invested into. The primary motivating factor in choosing investment is the expected returns to be generated. However, it should be noted that the decision in selecting the "right" investment is also largely dependent on the investor's perceived risk. It is irrefutable that most investors already have this preset conception of what type of investment is likely to give him more profits and gains in the future.
There is a widely held belief that an investment in the stock market is a no-win situation and only institutional investors reap profits. Thus, small investors concentrate on putting their money on government bonds, debt, and real estate. These decisions are somehow warranted due to the investor's aversion to risk. However, in addressing this situation, it is crucial to look at one of the core principles in finance-the risk-return concept.
The risk-return principle stipulates that the potential return of an investment rises with its potential risk (Risk-Return Tradeoff 2003). In other words, low risk investments generate low rewards to the investor while high risk ones presents probable returns. The risk and return principle clearly asserts that investors are faced with the tradeoff between risk and return. In line with this, an investment risk pyramid is devised in order to fully understand the equation of risk and return. The base of the pyramid is occupied by low risk-low return investments such as cash, cash deposits, notes, bills, and government bonds. It should be noted that these financial instruments often have a fixed return for a certain duration making investors less prone to financial default. The middle of the pyramid is occupied by medium risk investment like real estate, mutual funds, large/small capital stocks, and high income bonds and debt. At the peak of the pyramid, an investor is most likely to find options, futures, and collectibles as well as high risk securities (Determining Risk and Risk Pyramid 2003). Though the investments occupying the zenith of the pyramid are feared by investors because of their higher possibility of default, investors are entitled to higher rewards should they invest in high risk investments.
In conclusion, it can be seen that even small investors can win in the stock market. In fact, any investor putting his money in the stock market gains the possibility of generating higher than average returns. The high risk associated with investment in securities is warranted by high potential reward. However, these investors should overcome their risk aversion and have the knowledge of identifying stocks with high potential gains. As the risk-return principle has emphasized, high rewards entails taking huge amount of risks. It should also be stressed though, that it takes knowledge to choose good stocks and bravery to invest in securities.
References
Determining Risk and the Risk Pyramid, 2003, Retrieved 16 September 2006, from http://www.investopedia.com/articles/basics/03/050203.asp
Risk-Return Tradeoff, 2003, Retrieved 16 September 2006, from http://www.investopedia.com/terms/r/riskreturntradeoff.asp Read More
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