Any investments have risks, and investors have to recognize how much risks they should take on to obtain homologous profits. The investment risk is uncertainty of future return that investors may suffer the risk of profits loss or even capital loss. For instance, stock may be stuck, real estate may fall, and the company may be close down, etc. Generally, the greater the risk, the greater the potential return, or risk premium.
Expected return is the average of a probability distribution of possible returns. The excepted rate of return (ERR) is the rate of return expected on the asset or a portfolio which based on the weighted probability of all possible rates of return. Risk Premium is the difference between a rate of return and the risk free rate of return. Fair game is that a risky investment with a risk premium of zero.
Investors need to choose appropriate financial instruments according to their own investment objectives and risk performance. By analyzing the factors of risk, expected return and risk premium can judge decision-maker's risk attitude.
The concept of investment risk and the importance of risk attitude
Investor’s different attitude of risk will affect their final investment decisions. Generally, investors are divided into three types, risk averse, risk neutral and risk lover.
The feature of risk-averse investors is to pursue the lowest risk under a certain income level. They will prefer the one with risk-free assets or speculative prospects with positive risk premiums, such as, index funds and government bonds, and therefore they will stay away from high-risk portfolios or fair games. However, they will often lose out on higher rates of return. In addition, in order to compensate the risk they faced, risk-averse investors will reduce the expected rate of return of the portfolio by a certain percentage, and the greater the risk, the larger the range. For instance, if there are two choices, one is the person can get $100 with 100% chance, the other is they can get $200 with 50% chance. For risk-averse investors, they would generally settle for the "sure thing" and choose 100% chance to get certain $100.
Investors who are risk-neutral judge investment risk is more concern about their expected rates of return. They do not care about the level of investment risk, and investors have no risk barriers. For risk-neutral investors, a certainty equivalent rate of portfolio equals to its expected rate of return, and they do not need additional revenue to make up for risk undertaken. For instance, a risk neutral person would have no preference between the two options that either $100 with 100% certainty, or a 50% chance of getting $200.
Risk lover investors
In contrast to above two investors, a risk lover is willing to undertake additional risk for an investment which has a relatively low expected return. They pay more attention to return and ignore risk, and even take a fair games and gambles, they take the “fun” of risk into account, and when the rate of return is lower, they can get utility compensation by increased risk. For instance, in this case, risk lover will opt for the 50% chance of getting $200.
A range of financial instruments available from financial institutions
There are many financial institutions provides a variety of financial services for investors. It mainly consists of bank, insurance company, building society, national saving and investment (NS&I).
Bank is one of the most important financial institutions. The main task of it is to accept deposits and to make the loans. For savings, there are two accounts, transaction account and deposits account. Transaction account is that its holder can make withdrawals or make transfers to third parties through checks, drafts, online transfers,...