What is Risk?
Before understanding the concept of Risk and Return in Financial Management, understanding the two-concept Risk and return individually is necessary.
Risk is defined as the chance or probability of suffering loss due to future uncertainty. Since the future is uncertain, the future cannot be predicted due to this reason there is loss or in other words, there is some chance or possibility of suffering loss. This is known as Risk. In simple words, it is said that any chance or possibility or probability to face loss in the future is known as Risk.
Whenever a certain amount of money is invested in any of the investment tools or instruments, usually it is said how risky is this investment going to be. Now on what basis is this risk factor. This risk factor is on the basis of how much the probability or expectation is there or how many chances are there for the money to become zero hence in other words it is what the chance of probability that the money invested can reduce to some extent.
This concept will become clearer with the help of this example:
Suppose an individual is having $1000 and he decides to go to the bank and make an FD where he will get 8% annually. This means that at the annual time he is supposed to get $80. Here the risk percentage is 0. This is because no matter what happens, the bank is bound to pay 8% per annum no matter what the situation is going on.
Now if it is decided to invest this $1000 in the stock market rather than keeping it in the bank in the form of a fixed deposit, there is an uncertainty that the $1000 that has been invested can become $2000 lac or more and there is a chance that the complete $1000 can be lost when you do the movement of the stock market.
What is Return?
The gain or profit that an individual makes by investing in any investment tools or projects, is called Returns.
Suppose there is a project or business that you want to invest in. In other words, you were basically generating cash inflow into the business as a form of your investment. Therefore, there will be some cash outflow from the business or the project towards you. This cash outflow from the business or project is known as Return investment. The investment which you have done in the project or business it's some kind of return. This is known as Return on investment.
Importance of Risk and Return
The importance of Risk and Return in finance is in a way that how the individual wants to invest his or her money. The individual's choice of Risk and Return vary in all aspects. Some individuals are willing to take more risk in order to have more return whereas some individuals are risk-averse, which means that individuals want to invest their money in such assets or financial instruments where there is no risk. The above example where an individual puts his or her $1000 in the fixed deposit of a bank which is 8% interest per annum, is an example of risk-free investment. On the other hand, if the individual wants to invest in the stock market, knowing the amount of risk it is having, then the individual is having the choice of investing in the highly risky asset.
Relationship Between Risk and Return
There is a direct relationship between the amount of risk assumed and the amount of expected return. This means that if there is a high risk it also means that there will be higher expected returns. Therefore, the greater the risk larger will be the expected returns. It is very important to point out that there will always be a positive relationship between the risk and expected returns. The returns will not always be in the form of profit. If larger is the risk, then it is also expected that larger will be the possibility of loss. Here returns are taken in two dimensions one the return can be in the form of profit; the return can be in the form of loss as well.
This means that an investment is done where there is low risk, the returns can be expected (that can be in the form of profit or loss) to below. Similarly, if the investing is done with high risk, the returns can be expected to be high as well.
What is the Best Way to Invest for the Highest Return and Lowest Risk?
In this context, it is said that there is no best way to invest for the highest return with the lowest risk because it is already seen that there is a positive relationship between risk and return. One thing which can be done is minimizing the risk and maximizing the return to some extent. This can be done by portfolio management. Now the question comes that what is portfolio management? Portfolio management is nothing but the combination of various financial assets or financial instruments that the investor makes for himself or herself where there will be an amalgamation of both risk-free and risky assets. The trick here is to understand that even if the risky asset fails to give the proper return there are always other assets that will give the expected return to some extent.
The concept of portfolio management and risk and returns are closely related. Portfolio management helps in analyzing and evaluating the risk and return associated with the investment tools or instruments that the investor wants to invest in. There are mainly two investment objectives: the first is the maximization of returns and the second is the minimization of risk. Investment in the stock market involves high risk along with high returns [profit or loss] and investing in the bond market involves low risk and low returns. The two objects of investment are very conflicting. Therefore, there is a need for portfolio investment.
Context and Applications
This topic is significant in the professional exams for both undergraduate and graduate courses, especially for
- B.B.A. in Finance
- M.B.A in Finance
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