RISK AND RETURN ANALYSIS 6
Riskand Return Analysis
Relationshipbetween Risk and Return
Riskrefers to the probability of losing capital invested in a particularproject. Almost all investments carry risks. Investments that arecapable of delivering high returns are usually associated with highrisks while those that are not capable of yielding high returns havelow risks. Returns refer to the expected gains or losses from aninvestment and are expressed as percentages. The relationship betweenrisk and return is either direct or negative. The direct relationshipbetween risk and returns has two categories. The first categorystates that the higher the risk, the higher the returns (Lee et al.,2010). This implies that people who invest in hazardous investmentsstand better chances of getting high returns than those who invest inless risky businesses. The second class argues that the lower therisk, the lower the expected returns. If investors want to reduce therisk by investing little capital, then they should be aware that thereturns will also be limited. For instance, if the rate of return is10 percent and investor A invests one million dollars while investorB invests 10 million dollars. Then, A will get returns worth onehundred thousand dollars while B will get returns worth one milliondollars. However, if these investors were to lose, B would suffermore loss than A since A would lose one million dollars while B wouldlose10 million dollars.
Besides,there is a negative relationship between risk and return which hastwo categories. The first group states that the higher the risk, thelower the return. This type of relationship is often dictated by thenature of a project (Lee et al., 2010). For example, if there are100,000 lotteries of which an investor is required to buy 50 percentto earn a prize however, the value of the prize does not change evenif the investor buys 80 percent of the lotteries. All that increasesis the risk while the prize remains constant. This indicates thatsome ventures’ returns do not change even if the investors riskmore of their money thus the high the risk, the low the returns. Thesecond grouping states that the lower the risk, the higher thereturns. An example of such a project is investing in governmentbonds. If the government needs a lot of money in an emergency, thegovernment will be willing to offer high interest on its bonds andsecurities. Therefore, investors will use a little money to purchasethe bonds and securities yet they expect high returns. Another reasonwhy the government bonds have fewer risks than common stocks is thatthe government can use several ways such as taxation to raise revenueto pay for the bonds.
Exampleof Risk and Return
Anexample of a risk is an instance whereby a man who is close to hisretirement age decides to invest all his money that he had saved witha retirement benefit company in another project. In this particularproject, the man can gain huge profits, but at the same time, he canlose all his money. This is an example of a risk since there is noguarantee that this man will get the expected huge returns.
Anexample of return can be expressed by the scenario below. Assume aninvestor puts 5000 US dollars in an investment and assumes that heowns 10 percent of the shares in this investment. In a period of onefiscal year, the company’s assets have appreciated, and theinvestment is now worth 7500 US dollars. The rate of return oninvestments is calculated by getting the difference between thecurrent value and the original value, and the difference is dividedby the original value. That is, (7500-5000) is equal to 2500. Then,2500 divided by 5000 is equal to 0.5. However, the rate of return oninvestment is expressed in percentage. Therefore, the rate of returnon the 5000 US dollars investment will be 50 percent.
WhichIs More Risky Between Bonds and Common Stocks
Everybusiness offers a balance between the likely gains and the possibleloss. However, some businesses are considered to be less risky thanothers. For example, bonds are considered to be less risky than thecommon stocks for different reasons. Bonds usually have the promiseof their issuer of returning the par value of the security to theholder when the maturity time reaches. Stocks do not have such aguarantee at all. Also, bonds have a fixed rate of interest that isaccompanied by the promise of paying face value by the issuer whilestocks only pay dividends but no promise from the issuer (Hussain,2013). Furthermore, the returns on bonds have been historically lowerthan the returns on common stock (Lee et al., 2010). Since thoseinvestments that have low returns are usually associated with lowrisks, it can be concluded that bonds are less risky than the commonstocks.
HowUnderstanding Return and Risk Helps in Future Business Ventures
Understandingreturn will help a person in the future business venture bydetermining whether the investment or the company they want to puttheir capital in is viable. This will help in identifying the type ofproject that a person should venture in to avoid any disappointmentsin the future. Also, the knowledge of return calculation helps inassessing which projects will yield more profits as well as comparethe gains of one project with another project (Hussain, 2013).Besides, the calculation of the rate of return assists in determiningwhether a certain project in a company will be feasible. If thecalculation shows that the internal rate of return will be higherthan the capital to be invested, then the project is possible.
Havingthe knowledge of risks and risks management is very important to anyperson who wishes to invest now or in the future. Therefore,understanding risk is very vital since it helps in risk management.When venturing into a new business, risk management assists in riskidentification. Risk organization outlines the different types ofrisks that are likely to be faced by a new entrepreneur (Friedlob &Plewa, 1996). Such risks include operational, health, financial,safety, environmental among others. In turn, risk identification willassist in putting the preventative measures in place thus reducingthe probability of the risk occurrence. For example, if a risk ofmoney theft has been identified, then measures such as keeping moneyin safes or avoiding staying with a lot of liquid cash in businesspremises can be put in place to avoid money loss through theft.Furthermore, risk management will help in discussion of scams and howthey can affect the operations of business. This helps in filteringscams in business.
Friedlob,G. T., & Plewa, F. J. (1996). Understandingreturn on investment.New York: Wiley.
Hussain,O. K. (2013). Riskassessment and management in the networked economy.Heidelberg: Springer.
Lee,C. F., Lee, A. C., & Lee, J. C. (2010). Handbookof quantitative finance and risk management.New York: Springer.