Return and risk.. The relationship between return (profit) and risk (loss)
As an investor, you must know much more than just the basics to become an experienced and professional investor. To reach the advanced level of the investment journey, one needs to understand advanced concepts such as return and risk. Read this article to learn the concept of return and risk and understand the relationship between them.
The relationship between return and risk is based mainly on the idea that the potential return rises with the increase in risk, that is, the higher the risk, the higher the value or percentage of the potential return. Using this principle, investors associate low levels of risk and uncertainty with low potential returns, and high levels of risk and uncertainty with high potential returns. According to this principle, the invested funds can only achieve higher profits if the investor accepts the possibility of greater losses.
The concept of return (profit) and risk (loss)
The term “return and risk” refers to the potential financial loss or gain resulting from investments.
In investing, there is a close correlation between risk and return. Higher potential returns from an investment are usually closely related to higher risks. The main types of investment risks include project risks, industry risks, competitive risks, international risks, and market risks.
The rate of return indicates the gains and losses on an investment. Return on investment is expressed as a percentage and is a random variable that can take on any value within a given range. There are several factors that influence the type of returns that investors can expect from an investment instrument.
A return, also known as a financial return, in its simplest terms, is the financial gain made or lost on an investment over a certain period of time.
Return can be nominally expressed as the change in the value in dollars or other currency of an investment over time. But the return is often calculated as a percentage or percentage of the original investment, so that managers can measure and compare how well their investment is doing. The amount of return depends on a lot of different things, but the main influencing factor is the risk.
The brain is defined
Risk is defined in financial terms as the chance that the actual outcome or gain of an investment will differ from the expected outcome or return. Risks include the possibility of losing some or all of your original investment.
The concept of risk has many different definitions, but to keep things simple, it makes sense to think of investment risk in three ways:
1. You may lose some or all of your investment
When you make an investment, you hope that its value will increase and one day it will be sold for a profit. But there is no guarantee. There is always the possibility that you could end up losing part or all of your investment. Even if the value of your investment grows, there is no guarantee that it will live up to your expectations. You cannot rely on the past performance of an investment to be repeated in the future.
2. Your investment may be worth less in the future
It’s also worth noting that inflation (the rising cost of everyday goods and services) can erode the value of an investment over time. For example, if an investment returns 1.5% each year, but annual inflation rises 2%, the money invested will be worth less when you are looking to spend it. These “inflation risks” have become a greater concern in recent years, as ultra-low interest rates have reduced the returns available through cash savings accounts.
3. Your investment journey may be uncomfortable
Investments can be volatile, and the higher the risk of an investment, the greater the potential for unpredictability of its return. Alternatively, taking fewer risks should make your journey more comfortable, but may mean it takes longer to get to your destination.
The relationship between return and risk (profit and loss)
Knowing and understanding the relationship between return and risk can be very important for every investor because investors always want high returns with low risks. However, their ability to successfully identify the relationship between return and risk correctly may enable them to manage their investments better.
Understanding the relationship between return and risk is based on studying the impact of both elements on each other, as we measure the effect of increasing or decreasing risk on investment return. Below, we will identify the main types of relationships between risk and return:
The direct relationship between risk and return:
High risk – high return: According to this relationship, the more risk an investor can take, the more potential for higher returns.
Low risk – low return: If the investor reduces the investment. This means that it reduces the risk of loss. This means then that its returns will also be directly low.
The basic link between risk and return:
The correlation between risk and return is one of the cornerstones of financial theory. The greater the amount of risk an investor is willing to take, the higher the potential return on his investment. This is just another way of saying that investors get and should get compensated for taking on additional risk.
You may consider the following
Investing in government bonds is a safer and less risky investment than corporate bonds. Since the risks of investing in corporate bonds are higher than the risks of investing in government bonds, investors will need a higher expected rate of return to induce them to invest in company bonds rather than government bonds.
The additional incentive is required because the investor perceives the company’s bonds to be “riskier” than government bonds.
Diversification allows investors to reduce the overall risk associated with their investments or portfolios, but it may limit potential returns if diversification is abused or overestimated. For example, if someone invests in only one market sector, if this sector excels greatly, it will lead to achieving super and very high returns. However, in the event that this sector declines, it will achieve returns that are much lower than what it could have achieved through diversifying the investment portfolio.
Trade-off between return and risk
The inherent nature of the markets and investments, no matter what type of investment you choose, is such that potential investment returns are directly related to its risks. This phenomenon is known as the trade-off between return and risk.
Each type of investment comes with a certain level of risk, which can vary widely between two options. For example, stock shares are known to have the highest levels of risk in the financial markets. But there is no denying that they also have the highest potential returns. If you have chosen a quality stock, it can generate returns in excess of 10%-12% annually.
On the other hand, investment options such as banking CFDs come with minimal risks. But annual returns are generally in the range of 6%-7%. This concept does not only apply to financial markets. In every type of investment, be it stocks, mutual funds, the bullion market, or even real estate, this risk-return relationship is omnipresent.
Therefore, each investor must consider the trade-off between risk and return at the time of investment selection so that the level of risk aligns with the appetite for risk.
The appropriate trade-off depends on a variety of factors, including the investor’s risk tolerance, the investor’s years of retirement, and the ability to replace lost funds. Time also plays an essential role in identifying and finding a portfolio with appropriate levels of risk and return.
For example, if an investor has the ability to invest in stocks for the long term, this provides the investor with the possibility to avoid the risks of falling markets and participate in rising markets. In the event that the investor is able to invest in the short term only, the same shares can involve higher risks in this case.
Investors use the principle of comparison between risks and returns as one of the basic components that they rely on to make any investment decision and evaluate all types of investment portfolios in general. At the portfolio level, risk-reward tradeoffs can include assessments of concentration or diversification of holdings and whether the investment mix is too risky or has the potential for less than desirable returns.
Measure individual risk in context
When an investor is considering high-risk, high-return investments, the investor can apply the risk-reward trade-off on an individual basis, ie, to each investment he makes, as well as on an aggregate basis in the context of his investment portfolio as a whole. Examples of high-return, high-risk investments include options contracts, cheap stocks, and leveraged exchange-traded funds (ETFs). In general, a diversified portfolio reduces the risks involved in individual investment positions. For example, it might be a centerDiversified reduces the risks involved in individual investment positions. For example, a cheap stock position may have high risk on an individual basis, but if that position is the only one of its kind in a larger and diversified portfolio, then the risk that can be incurred from holding that cheap stock is negligible in that case.
The principle of trade-off between risks and returns at the portfolio level
The principle of risk-reward trade-off can also be applied at the portfolio level. For example, a portfolio made up of all types of stocks presents higher risk and higher potential returns. Within a portfolio containing all types of stocks, risk and return can be increased by concentrating investments in specific sectors or by taking Single positions account for a significant proportion of holdings. For investors, assessing the cumulative risk-return trade-off of all positions can provide insight into whether a portfolio is taking enough risk to meet its long-term return goals or if risk levels are too high with the current mix of holdings.
In general, it is wise to manage investment risks by knowing the concept of return and risk, the relationship between them and how to measure both return and risk. Understanding the risks that can apply to different scenarios and some ways to manage them comprehensively will help all types of investors and business managers avoid unnecessary and costly losses.
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