Risk Return Relationship

Explain the relationship between risk and return

As far as financial issues are concerned, a risk is basically the possibility of losing your hard-earned cash on an investment and a return is what you get out of an investment. However, what most people don’t understand is the relationship between risks and returns and how these two operate within the financial sector.Risks in terms of investment basically refer to the possibility of losing money on investment or having an investment that cannot keep pace with inflation. While all investments carry risks, the level of risks primarily depend on the type of investment. Ideally, those investment considered to carry higher risks generally have the potential of bring higher returns. On the contrary those investments that are considered to carry lower risks correspondingly deliver lower returns. Returns on the other hand refer to the amount lost or gained from an investment (Franco, 1973).

Risks and returns are fundamentally linked in the sense that the higher the potential of high returns from an investment the higher the risks associated with it. There is always a trade-off between risks and returns. The higher the level of risk taken, the higher the potential return. Lottery tickets for example provide a classic case of this relationship. The chances of losing money are very high in a lottery game. However, the potential return is ridiculously high. By the same token, an option such as savings account at a bank offers lower risks with a low potential return. Looking at these two spectrums of cases, it is important to appreciate the relationship between risks and returns and the trade-off that informs how they operate hand in hand (Franco, 1973).

Due to the extreme ends of the two case scenarios, people always opt for the middle of the spectrum. They choose to take a moderate risk whose return in moderate. This is made possible by spreading risks associated with investments. The relationship between risks and returns is therefore based on the level of risks carried vis-a vis the potential return.

 

Identify an example of risk and return

Lottery tickets are risks people carry with expectations of high potential returns. While lotteries are always portrayed as low-risk ventures, the fact behind lotteries is that the chances of losing are usually high compared to the possibility of winning. However, the potential return is always a good deal and more often than not, it acts as the driving factor behind why people engage in lotteries. This is an example of a risk. Winning a jackpot on the other hand is a return that comes as a result of taking the risk of gambling. Lottery as a gamble offers a jackpot as a return. Despite the chances of winning a jackpot are always limited given the wide range of probabilities, the potential of winning is rewarded by a handsome jackpot, sometimes a multi-million dollar.

A good example of a return is dividends earned from investing in stocks. Depending on the economic state defined by the level of inflation and related economic factors, dividends can either be high or low or non-at all. People always invest in stocks with an aim of earning dividends and their hope is always dependent on how favorable the interest rates are. Interest rates are determined by the economic strength of a nation (Selena, 2013). For this reason, it is a risk to invest in stocks buts there is always a potential return expected in terms of dividends.

 

Explain which is more; risky bond or common stocks

Generally, all investments offer a trade-off between risks and returns. The risk is the basically, the amount of money you stand to lose if an investment fails. A return is the amount if money you stand to make when an investment succeeds.  Bonds are considered less risky than stocks. While bonds carry the assurance of their issuer to return the face value of the security to the holder at maturity, stocks on the other hand offers no promise from the issuer and thus the holder has no guarantee of returns (Selena, 2013). Bonds are less risky compared to stocks in the sense that bonds pay investors using a fixed rate of interest on incoming reinforced by a promise from the issuer. More often than not, stocks pay in terms of dividends, however, the issues provides not a guarantee to make these payments. Additionally, the bond market has always been less vulnerable as compared to the stock market. While it is important to appreciate the fact that the bond market returns have been lower, it is equally important to appreciate the fact that the bond market has been more stable as compared to the stock market, despite stock market sometimes offering good returns.

Explain how understanding risk and return will help you in future business ventures

Entrepreneurs have been questioning the relationship between risks and returns to their companies by external capital investors. The three years of poor performance of the stock market has given insights to investors on the best business opportunities to choose from. When starting a business venture it is important to define risks associated with the business venture. This will ensure the business venture is ranked as either more risky or less risky. With respect to today’s very tight funding market, capital providers are equally concerned with business ventures for which they channel their funds towards to (David, 2003).

As a prospective investor, the knowledge of the relationship between risks and returns is an important aspect in coming up with any investment. One way in which this understanding will help me in my future business venture is to guide my decision on the choice of investment. Having known that risky investments come along with potential high returns and vice versa, I believe that life in itself is a risk and the risks we take are all dependent on the measure we take to counter these risks. However, there are limits to what level of risks an individual should take especially when it is the first business venture (David, 2003). Established businesses, however, have the capacity to pursue more risky business ventures because they already have a landing point in case of disappointments.

In conclusion, the choice of an investment is solely dependent on the risks and returns involved. The more risky the investment the fewer the number of participators and vice versa. The profitability of  a business venture is also determined by the level of risks taken to pursue the venture. People for fear of losing money to risky investment will always spread their risks by investing on moderately risky businesses.

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