The risk and return associated with any type of investment bear several similarities. The more the “appetite” for high returns, the higher the level of risk a business entity has to accept. In other words, risks and returns are directly proportional to each other when it comes to investment (Greenwood & Shleifer, 2014).
One aspect that both investors and speculators have to constantly deal with is the need to balance risk and return. As a general rule, the higher the risk associated with an investment, the greater the return that can be accrued. While this is true, there are other factors to take into account to determine the degree of risk in relation to the offered return. Some factors may be crucial in order to assess the risk in relation to return.
To begin with, the term volatility refers to the rise or fall of price of a financial asset. What happens is that markets are always evaluating what is happening to get an estimate of what will happen in the future. This means that future events may cause prices to rise or go down dramatically (Greenwood & Shleifer, 2014). Such large variations are the basic concept of volatility and a typical example of risk.
In any type of investment, there are different types of risks that businesses should understand in order to decide whether a particular investment is suitable. Some of these risks include:
- Market risk – the risk which provides the positive and negative movements that always occur in the stock market.
- Political risk – the risk of a country’s change of policies which may affect what has been invested.
- Risk of interest rates – the value of investment may be affected by changes in interest rates.
- Credit risk – when a particular company or individual is unable repay the principle amount loaned out.
- Country risk – the risk associated with a particular country not being able to pay its financial obligations.
- Risk of foreign exchange – when the changes in a country’s exchange rate affect investment (Greenwood & Shleifer, 2014).
Any amount invested in a business entity may lead to a loss or gain. The latter is referred to as a return. Investment returns are the key determinants of profitability of a business. For example, if a business enterprise invests a sum of US$1million at the beginning of a fiscal year and then makes a profit of US$ 200,000 by the end of a given trading period, the profit margin would be referred to as a return.
Bonds and common stocks
Large investments are usually associated with high risks. On the same note, corporate bonds and common stocks carry various risks. However, it is vital to mention that corporate bonds often yield lower returns than common stocks, and therefore, they tend to bear lower risks (Bansal & Shaliastovich, 2013). The fact that corporate bonds generate regular dividend payments does not imply they are profitable. The potential returns generated by common stocks are far much higher owing to the risks they carry.
The bond market is mainly dominated by those issued by companies. Since the performance of most companies is usually stable at the time of issuing bonds, the associated risks are generally low. In the event that a company is declared unable to pay its debts, it cannot be in a position to repay the face value of a bond already issued (Bansal & Shaliastovich, 2013).
On the other hand, individual investors become shareholders in companies after buying common stocks during IPO. In order for a shareholder to gain after purchasing shares, most companies remit dividends. Stock exchange trading can also generate some income for a company. The latter increases Return on Investment (RoI) for shareholders unlike the case of corporate bonds. Nevertheless, common stocks face numerous risks such as sudden drop in the value of shares, loss of money paid out for stocks and unfavorable changes in the stock exchange market.
Understanding risks and return is crucial before starting or venturing into business. To begin with, this knowledge assists in appreciating the fact there is no single business entity that lacks risks in spite of its size (Ciner, Gurdgiev, & Lucey, 2013). However, it is prudent to evaluate the degree of risk and estimate whether a business portfolio will be able to put up with it. After acquiring knowledge on business risks, it is possible to assess each risk rationally and weigh the pros and cons before starting a business.
Second, learning and comprehending the concepts of risks and returns can inject the much needed skills and knowledge on how to set business goals as far as profitability is concerned (Ciner et al., 2013). As already mentioned, businesses with lower risks are likely to yield lower returns. This implies that by venturing into business, an entrepreneur can make the right decision on profit margin expected. Businesses that operate within “comfort zones” and encounter minimal risks are anticipated to be less profitable. Therefore, understanding risks and returns can assist an entrepreneur to boost the profitability of a firm.
Bansal, R., & Shaliastovich, I. (2013). A long-run risks explanation of predictability puzzles in bond and currency markets. Review of Financial Studies, 26(1), 1-33.
Ciner, C., Gurdgiev, C., & Lucey, B. M. (2013). Hedges and safe havens: An examination of stocks, bonds, gold, oil and exchange rates. International Review of Financial Analysis, 29(1), 202-211.
Greenwood, R., & Shleifer, A. (2014). Expectations of returns and expected returns. Review of Financial Studies, 27(3), 714-746.