The Importance of the Risk and Return Balance
BUS 401 Principles of Finance
Can we ever have any return without some type of risk?
It is not possible to have any return without some type of risk. This is because all kinds of investments are characterized by a certain risk. The only possible scenario is to have a return with minimal risk. In the investment sector, government securities such as treasury bonds are considered as having minimal risk. However, investing in such securities does not necessarily guarantee that the investor will yield a return. Such investments are prone to different risks such as political instability. This is a perspective that indicates that it is not possible to have any return without some type of risk. The rate of return and risk in return represent the dimensions of expectation and uncertainty. The tradeoffs between them are real and faced by individuals and businesses frequently. The decision to invest involves a choice among alternatives having both varying anticipated return and risk. Being averse to risk, individuals and businesses choose the least risky investment for a given level of anticipated return, or require a greater return when investments are riskier. The investor perspective with respect to risk tends to be one of concern with the degree to which returns might depart (or vary) from the expected level. Risk is a fundamental component of investment (Walter, 2012) This implies that investors must always evaluate the risk factor of an investment in order to project about the potential returns. There are numerous variables that characterize the return yielded from an investment. These returns constitute the risk for each investment. This is another essential perceptive that illustrates that returns are not obtainable without some type of risk. The relationship between risk and expected return is first described by the capital asset pricing model (CAPM), which links expected return to a single source of risk, and second, by models that include additional factors to explain returns. (Hickman, K.A., Byrd, J. W. & McPherson, M., 2013) Although the capital market line holds for efficient portfolios, it does not describe the relationship between expected return and risk for individual assets or inefficient portfolios. In equilibrium, the expected return on a risky asset (or inefficient portfolio). While the CAPM is clearly an incomplete explanation of the relationship between risk and returns, it is important to note that it is still widely applied. They are two types of risk:
Unsystematic risk (also referred to as diversifiable or unique risk) includes risk events that affect single firms only (e.g. an employee strike, a failed product launch etc.). Systematic risk (also referred to as non-diversifiable or market risk) includes risk events that affect the entire economy or entire market (i.e. all firms). Unsystematic risk can be reduced or even eliminated through diversification, which means holding an investment portfolio with many different kinds of shares and other types of assets. As an example, firm A in your investment portfolio might have a failed product launch, but firm B in your portfolio might have a huge hit. Holding only shares in firm A means your returns will decrease, but holding shares in both firm A and B means the bad outcome for firm A might be cancelled out by the good outcome for firm B. Since it is possible to eliminate this type of firm-specific risk through diversification, an investor cannot be expected to get extra compensation for taking on this type of risk. Systematic risk, on the other hand, cannot be diversified away. These are economy-wide or market-wide events and most firms cannot escape these events. Hence, holding a diversified investment portfolio will not help to reduce or eliminate this type of risk and therefore investors are rewarded for taking on this type of risk. In short, only...
Please join StudyMode to read the full document