Explain risk and return relationship

Risk–return spectrum - Wikipedia

explain risk and return relationship

Definition: Higher risk is associated with greater probability of higher return and lower risk with a greater probability of smaller return. This trade off which an. The risk–return spectrum is the relationship between the amount of return gained on an . If every mid-range return falls below the spectrum line, this means that the highest-risk investment has the highest Sharpe Ratio and so dominates over . Risk-return tradeoff is a specific trading principle related to the inverse relationship between investment risk and investment return. WHAT IS THE Risk -Return Tradeoff. The risk-return tradeoff states that the potential return.

To start with have a look at the average historical returns given by these 2 assets, i. One glance at the table above and it becomes clear - which is the better asset to invest in,given the historical average returns. Another thing to note here is that returns given by bank deposits will be further reduced when we consider taxes.

This makes stocks all the more better option for long-term investing. Stocks are volatile and can move up or down sharply. This is unlike bank deposits, which are almost guaranteed to give fixed returns promised at the time of booking the deposits. But before you draw a negative conclusion about stocks, it is important to understand that its the very nature of stocks as an asset classwhich makes it a volatile asset class for the short term.

But when you increase the period under review, its found that stocks and equity mutual funds give much higher average returns than what is given by bank deposits, or for that matter, any other asset class. Just have a look at the table below which builds on the previous table: Stocks are clear winner.

explain risk and return relationship

But nothing comes for free in this world. Same is the case with high returns of stocks. These come at a cost -higher volatility in the short-term. Or looked at from another perspective, an investor in stocks needs to be compensated for taking higher risks.

This is achieved by means of higher returns that stocks provide. Understanding this relationship between risk and return is very important and can help an investor make correct financial decisions, based on their risk appetite and return requirements. A very formal definition of risk is the likelihood that actual returns will be less than historical and expected returns. But to put it very simply, risk is the possibility of losing your money that is invested as principal.

For example — You invest Rs 20, in stocks today. Next day, the markets go down and reduce the value of your investments to Rs 18, That is the primary risk when you invest in stocks. There is no guarantee that you will actually get a higher return by accepting more risk. Diversification enables you to reduce the risk of your portfolio without sacrificing potential returns.

  • Risk and Return
  • Risk Return Trade Off
  • Risk–return spectrum

Once your portfolio has been fully diversified, you have to take on additional risk to earn a higher potential return on your portfolio.

GICs and bank deposits also carry low risk because they are backed by large financial institutions. With these low-risk investments you are unlikely to lose money. However, they have a lower potential return than riskier investments and they may not keep pace with inflation.

explain risk and return relationship

Learn more about the risks of bonds. Stocks have a potentially higher return than bonds over the long termTerm The period of time that a contract covers. Also, the period of time that an investment pays a set rate of interest. BondBond A kind of loan you make to the government or a company.

Understanding the relationship of Risk & Return

They use the money to run their operations. Equity[ edit ] Equity returns are the profits earned by businesses after interest and tax. Even the equity returns on the highest rated corporations are notably risky.

Small-cap stocks are generally riskier than large-cap ; companies that primarily service governments, or provide basic consumer goods such as food or utilities, tend to be less volatile than those in other industries.

Risk/return relationship

Note that since stocks tend to rise when corporate bonds fall and vice versa, a portfolio containing a small percentage of stocks can be less risky than one containing only debts. Options and futures[ edit ] Option and futures contracts often provide leverage on underlying stocks, bonds or commodities; this increases the returns but also the risks.

Note that in some cases, derivatives can be used to hedgedecreasing the overall risk of the portfolio due to negative correlation with other investments.

For example, the more risky the investment the more time and effort is usually required to obtain information about it and monitor its progress.

explain risk and return relationship

For another, the importance of a loss of X amount of value is greater than the importance of a gain of X amount of value, so a riskier investment will attract a higher risk premium even if the forecast return is the same as upon a less risky investment. Risk is therefore something that must be compensated for, and the more risk the more compensation required. If an investment had a high return with low risk, eventually everyone would want to invest there.

Understanding the relationship of Risk & Return - Tradejini

That action would drive down the actual rate of return achieved, until it reached the rate of return the market deems commensurate with the level of risk.

Similarly, if an investment had a low return with high risk, all the present investors would want to leave that investment, which would then increase the actual return until again it reached the rate of return the market deems commensurate with the level of risk.

That part of total returns which sets this appropriate level is called the risk premium. Leverage extends the spectrum[ edit ] The use of leverage can extend the progression out even further. Examples of this include borrowing funds to invest in equities, or use of derivatives. If leverage is used then there are two lines instead of one.

explain risk and return relationship

This is because although one can invest at the risk-free rate, one can only borrow at an interest rate according to one's own credit-rating. This is visualised by the new line starting at the point of the riskiest unleveraged investment equities and rising at a lower slope than the original line.

explain risk and return relationship