- 1 the concepts of return on investment and risk
the concepts of return on investment and risk
The Concepts of Return on Investment & Risk
Investments result in a profit or loss, known as the return.
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When you invest in your business or put your profits into an investment vehicle, you can determine what your potential return is. You must also examine the amount of risk you take. In other words, you could lose all or part of your money. Understanding how potential returns and risk work together can help you evaluate investment opportunities and make informed decisions.
When any given investment opportunity seems to have higher risk than other opportunities, its value may fall. The reason for this is that investors expect to be compensated for taking on extra risk. If they could put their money in a safer investment at the same price, they wouldn't consider the risky investment. However, if they receive a discount, they may be willing to put their money to work in an opportunity. For example, if you own a start-up business that the bank considers a risk for failure, it may loan you a reduced amount than it would a large corporation, because your company has less value.
The higher the risk for an investment, the higher the potential returns. Any time you want to make a higher percentage rate or capital gain than most people make, you have to consider taking on more risk. That's why bonds of companies with bad credit ratings pay higher interest. The company could fail and the bonds could become worthless. A nice, steady investment in a blue chip stock historically yields lower returns than the stocks of successful start-up companies. If you decide to invest in a joint venture, you can evaluate the risk involved. If that risk seems high, you can ask for a guarantee of higher returns by getting a better percentage of profits to compensate you for taking the risk.
You don't have to take on high risk for an entire portfolio. Instead, you can spread the risk by putting money to work in safe, moderate and risky investments. The percentages you decide upon are up to you, but you can tailor your mix to your own risk tolerance. This approach gives you the opportunity to make exceptional gains on riskier investments, while keeping a portion in safer investments that pay a lower return. In the event your risky investment fails, you will have some funds to use for recovery.
You must know the debt of any company you invest in. Whether you buy stock in a company, purchase corporate bonds or sink your money into a new venture, excessive debt can undermine your investment. To put it simply, the company must earn enough to make a profit after making debt payments. Failure to do so will result in company failure. Investments that look like they could offer high returns may be masking the fact that the company has been growing by borrowing. The higher the debt, the higher the risk of failure.
Kevin Johnston writes for Ameriprise Financial, the Rutgers University MBA Program and Evan Carmichael. He has written about business, marketing, finance, sales and investing for publications such as "The New York Daily News," "Business Age" and "Nation's Business." He is an instructional designer with credits for companies such as ADP, Standard and Poor's and Bank of America.
Financial Concepts: The Risk/Return Tradeoff
- Financial Concepts: Introduction
- Financial Concepts: The Risk/Return Tradeoff
- Financial Concepts: Diversification
- Financial Concepts: Dollar Cost Averaging
- Financial Concepts: Asset Allocation
- Financial Concepts: Random Walk Theory
- Financial Concepts: Efficient Market Hypothesis
- Financial Concepts: The Optimal Portfolio
- Financial Concepts: Capital Asset Pricing Model (CAPM)
- Financial Concepts: Conclusion
Risk and return are opposing concepts in the financial world, and the tradeoff between them could be thought of as the “ability-to-sleep-at-night test.” Depending upon factors like your age, income, and investment goals, you may be willing to take significant financial risks in your investments, or you may prefer to keep things much safer. It’s crucial that an investor decide how much risk to take on while still remaining comfortable with his or her investments.
For investors, the basic definition of “risk” is the chance that an investment’s actual return will be different from what was expected. One can measure risk in statistics by standard deviation. Because of risk, you have the possibility of losing a portion (or even all) of a potential investment. “Return,” on the other hand, is the gains or losses one brings in as a result of an investment.
Generally speaking, at low levels of risk, potential returns tend to be low as well. High levels of risk are typically associated with high potential returns. A risky investment means that you’re more likely to lose everything; but, on the other hand, the amount you could bring in is higher. The tradeoff between risk and return, then, is the balance between the lowest possible risk and the highest possible return. We can see a visual representation of this association in the chart below, in which a higher standard deviation means a higher level of risk, as well as a higher potential return.
It’s crucial to keep in mind that higher risk does NOT equal greater return. The risk/return tradeoff only indicates that higher risk levels are associated with the possibility of higher returns, but nothing is guaranteed. At the same time, higher risk also means higher potential losses on an investment.
On the safe side of the spectrum, the risk-free rate of return is represented by the return on U.S. Government Securities, as their chance of default is essentially zero. Thus, if the risk-free rate is 6% at any given time, for instance, this means that investors can earn 6% per year on their assets, essentially without risking anything.
While a 6% return might sound good, it pales compared to returns of many popular investment vehicles. If index funds average about 12% per year over the long run, why would someone prefer to invest in U.S. Government Securities? One explanation is that index funds, while safe compared to most investment vehicles, are still associated with some level of risk. An index fund which represents the entire market carries risk, and thus, the return for any given index fund may be -5% for one year, 25% for the following year, etc. The risk to the investor, particularly on a shorter timescale, is higher, as is volatility. Comparing index funds to government securities, we call the addition return the risk premium, which in our example is 6% (12%-6%).
One of the biggest decisions for any investor is selecting the appropriate level of risk. Risk tolerance differs depending on an individual investor’s current circumstances and future goals, and other factors as well.
Concepts of Return on Investment & Risk
by Chris Joseph
Everyday life is full or risk. When you drive to work, you run the risk of getting plastered by an 18-wheeler, and the simple act of stepping off a curb could turn deadly if you're not careful. But to get anywhere or accomplish anything in life, you'll probably have to take at least some risk to receive a reward in return. This concept is also true when it comes to investing your hard-earned money.
Return on investment (ROI) is the amount of money you receive (or lose) in relation to the amount you invest. ROI takes into account things like interest rates, additional purchases, withdrawals and expenses when determining the overall profitability of your investment, Risk is the probability that your investment will gain or lose money. Before investing, you also need to consider your risk tolerance, which is your level of comfort with and your ability to absorb a loss if it occurs.
Higher Risk Can Mean Higher Rewards
When it comes to investing your money, the more risk you are willing to take, the better your chances of earning a high return on your money. On the other hand, there's also a greater chance that your investment will crash and burn. High-risk investment products like penny stocks, aggressive growth mutual funds and foreign company stocks tend to be more volatile because of their speculative nature. For instance, a stock investment in a company located in a country with an unstable government could go south quickly if the regime changes.
Low-risk investments offer a larger degree of safety. If you put your money into a savings account at your local bank, you can take comfort knowing that your money is insured up to $250,000 by the Federal Deposit Insurance Corporation (FDIC). Of course, in exchange for the safety you'll receive a minuscule interest rate, meaning your return on investment over time will also be small.
You could always decide to avoid risk at all by keeping your money in your piggy bank or under your mattress. While your money is completely safe, unless a burglar steals your piggy bank or you accidentally set the mattress on fire, your return on investment will be zero. You may also have great difficulty in achieving financial goals like having enough money for retirement or for your kids' college education.
Chris Joseph writes for websites and online publications, covering business and technology. He holds a Bachelor of Science in marketing from York College of Pennsylvania.
The Concepts of Return on Investment and Risk
Maximizing returns requires taking calculated risks.
profit/loss1 image by Warren Millar from Fotolia.com
Return on investment is the profit expressed as a percentage of the initial investment. Profit includes income and capital gains. Risk is the possibility that your investment will lose money. With the exception of U.S. Treasury bonds, which are considered risk-free assets, all investments carry some degree of risk. Successful investing is about finding the right balance between risk and return.
Historical return on investment is the annual return of an asset over several years. Research analysts and professional investors use historical returns, along with industry and economic data, to estimate future rates of return. You can use actual results and estimated returns to evaluate various assets, such as stocks and bonds, as well as different securities within each asset category. This evaluation process helps you pick the right mix of securities to maximize returns during your investment time horizon.
Risk is the likelihood that actual returns will be less than historical and expected returns. Risk factors include market volatility, inflation and deteriorating business fundamentals. Financial market downturns affect asset prices, even if the fundamentals remain sound. Inflation leads to a loss of buying power for your investments and higher expenses and lower profits for companies. Business fundamentals could suffer from increased competitive pressures, higher interest expenses, quality problems and management inability to execute on strategic and operational plans. Weak fundamentals could lead to declining profits, losses and eventually a default on debt obligations.
You cannot eliminate risk, but you can manage it by holding a diversified portfolio of stocks, bonds and other assets. The portfolio composition should be consistent with your financial objectives and tolerance for risk. Investment returns tend to be higher for riskier assets. For example, savings accounts, certificates of deposit and Treasury bonds have lower rates of return because they are safe investments, while long-term returns are higher for growth stocks and other riskier assets.
Life events will require adjustments to your financial plan, including the asset mix in your investment portfolio. For example, the stock component of your portfolio may be high when you start your first job because you can afford to take more risks and want to grow your investments as quickly as possible. Your portfolio may change to a balanced mix of stocks and bonds when you start a family and switch to mostly bonds and dividend-paying stocks as you get closer to retirement. Market movements may also require periodic portfolio adjustments. For example, you may take some profits in stocks following a sharp stock market rally or invest in quality stocks at bargain prices after a sharp market correction.
- profit/loss1 image by Warren Millar from Fotolia.com
Based in Ottawa, Canada, Chirantan Basu has been writing since 1995. His work has appeared in various publications and he has performed financial editing at a Wall Street firm. Basu holds a Bachelor of Engineering from Memorial University of Newfoundland, a Master of Business Administration from the University of Ottawa and holds the Canadian Investment Manager designation from the Canadian Securities Institute.
The Concepts of Return on Investment & Risk
Making investment decisions really boils down to a simple calculation: Is the potential profit you could make from an investment worth the risk you'd have to assume? Profit potential is measured by projected return on investment -- how much you could expect to get back for what you put in. Risk is the uncertainty involved. The two are directly related. An investment that presents high risk needs to offer high potential return to entice investors. A safe, low-risk investment can offers a lower return.
The term refers to how much money is gained or lost after an investment. If you invest $1,000 and get back $1,080, you have an $80 (8 percent) return on the investment.
A negative return looks like this: You invest $1,000 and a year later only $900 remains. Return in this case was negative $100, or negative 10 percent. The percentage is in relation to original amount invested.
Gains and losses do not balance out with percentages. For example, $1,000 invested has a -10 percent annual return. So a year later, $1,000 is reduced to $900. Now, if that $900 had a 10 percent positive annual return the year after that, 10 pecent of $900 is $90. Therefore, the total after two years is $990, less than the starting $1,000. The numbers work slightly against the investor even though percentages even out.
Risk is a comprehensive term. It encompasses probability and magnitude of a loss. Buying stock allows a possibility that amount invested disappears from your account as the company goes out of business. That is bigger risk than buying a well-rated bond in terms of depreciation probability. A well-rated bond is less likely to give negative return on investment than stocks. Therefore, as a general rule, stocks have a higher depreciation probability.
Risk increases if loss exceeds amount invested even if loss probability remains unchanged. Consider short-selling. The likelihood of stock ABC decreasing in value remains the same regardless of buying equity or short-selling. If $1,000 worth of ABC stock doubles in value, a short-seller has to pay $2,000, which is a negative 100 percent ROI. But if ABC stock triples in value, you have to pay $3,000, realizing a negative 200 percent ROI. Magnitude of possible loss is crucial in quantifying risk.
Higher risk corresponds to higher returns. Let’s examine what influences bond interest rate. If the seller has a record of success, people will feel comfortable giving the seller money for a promised return later. The seller knows this, and therefore can offer a low rate. A buyer may feel safe and therefore purchase the debt, or not if they decide that the low return isn’t worth having their money tied up with the issuer for years.
By contrast, if the bond issuer has a questionable reliability record, it will take promise of a larger return (a "junk bond") to entice investors. A buyer may be greedy for the possibility of high returns and purchase the bond or decline by deciding the potential payoff isn’t worth the possibility of losing some, if not all, of the original invested amount.