The Relationship between Risk and Return

The Risk-Return Connection

The risk-return connection states that the larger the risk of an investment, the greater the likelihood of higher investment returns. All financial decisions typically contain risk, and knowing the risk-return relationship should serve as a guideline for making sound financial decisions (National Financial Inclusion Taskforce, 2016).

Return and Risk

Return is the financial consequence of an investment, whereas risk is the possibility of a loss in relation to the projected return on a certain investment. It is the degree of uncertainty associated with achieving the desired return. Time should be one of the fundamental aspects to be taken into consideration when carrying out investment decisions. The risk on an investment depends on inflation.

The Relationship Between Risk and Return

The level of risk does vary in relation to the expected return. Higher returns on an investment are directly related to a higher level of risk and this scenario is referred to as growth assets. On the other hand, if an investment carries a lower risk, which is also called defensive risk, the level of return will also be lower. The range of an investment risk emanates from various sources which depend on the investment criteria. The value an investor loses or earns from an investment is called a return on investment. Defensive assets are influenced by variations in the investment markets, economic status, political and social factors which would either lead to an increase or a decrease in the value of an asset. Therefore, these factors influence the return on an asset.

Capital Asset Pricing Model (CAPM)

Capital Asset Pricing Model (CAPM) is the method used to predict the rate of return and risk associated with an investment in finance. CAPM is a financial model used to value securities, stocks, and provides a blueprint to the determination of the return and risk associated with an investment basing on the demands of the investor (McClure, 2015). This form of financial modeling clearly provides a forecasted relationship between the risk on an asset and the expected return. CAPM is significant in giving a benchmark rate of return on an invested asset and also assists the investor in formulating informed decisions concerning the expected return on an asset. An important fact to note is that an investor has to make decisions when he or she is assured of a higher return in the long-run. Trade-off is usually used to represent the association between return and risk. In a nutshell, the more risk one takes on an investment the higher the probability of earning greater returns. A good example of this can be illustrated by lottery tickets which carry a huge risk of losing the money invested but have extremely higher rewards when a person wins.

Example of a Risk and Return

In illustrating an example of a risk and a return, the real estate investment of housing will be considered. Real estate investment involves buying lands and building materials together with labor to create real estate properties. Investment in this field normally consumes a lot of time and thus is a long-term investment. Furthermore, it requires a huge capital investment which also comes with enormous revenue, ceteris paribus. If the houses built are sold at a higher price than the total cost involved in the process, it constitutes a return. A positive net present value makes a return. For example, suppose the total cost used accumulated to $400,000 whereas the sold price is $500,000, therefore, $100,000 is the return. However, economic cycles could make the investor of the real estate incur losses. The widespread risks associated with this investment comprise liquidity and financial loss, changes in the prices of raw materials, increase in interest rates, and variations in the inflation rate which could lead to a reduction in the purchasing power of money and thus making the investor make losses.

Comparison of Risk on Bonds and Common Stock

In an investor’s portfolio, bonds and stocks build the major classes of the invested asset. Stocks are risky to invest in compared to bonds. This is attributed to the reason that common stock bears the highest risk as holders of the stock are the last ones to be paid in cases where a company is rendered bankrupt. Common stocks typically contain higher yields compared to bonds. Bonds also have lower returns in their dividend payment compared to the share value of stock. Common stocks provide an ownership stake in a company in which a shareholder has invested, whereas bonds do not have this provision. Due to ownership, the shareholders are able to formulate vital decisions that relate to the company. This makes them riskier. Stocks are also very volatile as compared to bonds although the level of volatility depends on the type of stock. Corporate bonds tend to have the lowest level of risk attached to them. An explanation for this is that in an event a company goes bankrupt, the holder of this type of bond has a strong eligibility and a claim for payments, unlike the preferred stockholder (Harms, 2015). Besides, convertible bonds are less risky than common stocks because these types of bonds tend to have both characteristics of stock and bonds. This makes them enjoy the merits and the demerits of investing in both securities. The fact that an equity shareholder gets the last preference of payment after dividends on bonds are paid in an incident of company liquidation also makes stocks riskier for investment compared to bonds.

References

Harms Leann. (2015).The Risks of Bonds Vs. Stocks. The Nest. Retrieved on January 18, 2017, from http://budgeting.thenest.com/risks-bonds-vs-stocks-4198.html

McClure Ben. (2015). The Capital Asset Pricing Model: An Overview. Investopedia. Retrieved on January 18, 2017, from http://www.investopedia.com/articles/06/capm.asp

National Financial Inclusion Taskforce. (2016). The Relationship between Risk and Return. Retrieved on January 18, 2017, from http://www.nfitfiji.com/personal-finances/the-relationship-between-risk-and-return/