Elevated Risk Leads to Greater Rewards: Finding the Right Balance of Risk.

DN89...Jybs

31 Mar 2024

There is a general principle in finance that goes “Higher risk higher return”. Or in corollary, “To achieve a higher return, one has to take the higher risk”. This is known as the risk-return tradeoff in finance. When an investor chases a greater return on investment, he needs to take a higher level of risk. For a low return on investment, the risks are also relatively low. This trade-off that the investor faces between the risk and return in his investment decisions is known as the risk-return tradeoff.

The major question is- Is there such a thing as a higher risk higher return? Can’t the investor achieve greater returns through low-risk investments? How can investors perceive the level of risks they are working on? The answers to these questions lie in the understanding of risks.

Risk

Risk is the chance of variability of return. In other words, a risk is a probability that the intended result may not occur. When you do anything, there is a chance that there may be a deviation from the result you seek. Starting a business has a risk of losing a part or all of the money in it. An entrepreneur hopes to make a huge profit in his ventures. However, there is a likelihood that the business will fail. Basically in finance, there are several risks such as market risk, systematic risk, credit risk, interest rate risk, exchange rate risk, and others.

Return

The other side of the coin is the return which is the achievement of the intended result. In finance, the return is the profit generated from the investment. If you put $1,000 on a fixed deposit in a bank at an interest rate of 10 percent, you will gain $100. This $100 is the return on your investment. Every person takes the risk with the hope of gaining a satisfactory return on their investment.

Does higher risk equal higher return?

Yes. Higher risks equal higher returns. Sometimes, you may feel like you are achieving a higher return at low risk. But that is not the case. This is because you may have underestimated the level of risks you were working on. It is hard to fathom the risk because it cannot be easily quantifiable. Although there are measurements of risk such as standard deviation, Value at Risk (VaR), etc, the risk is a subjective element. On the other hand, the return is easily calculable. Hence, it is likely that you could correctly measure your return after you achieve it. Whereas you tend to underestimate the risks associated with it, especially after you succeed in your endeavor.

We can understand the risk-return trade-off by comparing the variable return and fixed return Investment.

Variable Return Vs Fixed Return Investment

Variable return investment is the type of investment in which the future returns are unpredictable or uncertain. If you invest in such investments, you won’t know what you will gain from it. The returns are incalculable. On the other hand, in the fixed return investment, you know what you expect to gain from it. Let’s compare variable and fixed return investment in two ways as below:

1. Stock Vs Fixed Income Securities (Bond/Fixed Deposit/Money market securities)

Stock is a variable return investment since the returns from it are highly uncertain. You cannot know what you will get in dividends next year. The dividends depend on the earnings which depend on the business performance which depends on several other factors. You can make a general estimation but you won’t know for sure.

On the other hand, in a bond or fixed deposit, you know the return you will get by investing in them. If the coupon rate is 10 percent on bond, your return is 10 percent of your investment amount. Hence, the return from the bond or fixed deposit is known. And you will likely get those returns until maturity. Hence, they are a fixed-return investment.

Between stock and bond/fixed deposit, there is a higher return from the investment in stocks. This is because there is a higher risk in stocks. Historically, stocks have provided greater returns than bonds/bank deposits. However, investing in stocks has caused greater losses to investors during the period of market decline. One cannot expect safety from investments in stocks like in fixed deposits. Likewise, one cannot expect a higher return by putting money in fixed deposits like investing in stocks.

There are times when stocks are relatively low-risk securities. Likewise, there are times when bonds or fixed deposits will outperform the return from stocks. However, considering the long-term investment horizon, the stock will outperform the bond/fixed deposit. On the other hand, it will also carry higher risks than fixed-income securities.

2. Business Vs Job

Likewise, comparing the job to business is another way of looking at a risk-return tradeoff. A regular job provides a stable income and one can expect the income to continue for the foreseeable future. The income from the job carries little risk. If we look at the business, the earnings are uncertain and are highly fluctuating. Thus, the job is relatively safer than the business in terms of risk associated with it.

However, the business has a higher chance of providing greater returns if you are successful in it. Also, there is a higher failure rate in the business. More than 50 percent of businesses fail within the first five years of operation. So, there is more chance of failure than business success. But the successful businesses will have far more payoff than secure jobs.

Conclusion

Risk is everywhere. Risk is part of everyday life. You don’t need to take a higher risk for higher returns. You should take the risk at the level of your tolerance. If you can face the worst outcome from your endeavor, that is your level of risk. Suppose, I purchase stocks of $1,000 and lose it all. If that loss heavily affected my day-to-day life, then my investment endeavor was not worth risking. Even if I had profited $5,000 (instead of a loss in the first case), the investment was not worth taking the risk.

So, taking a risk doesn’t only depend on the return. It also depends on the level of risk tolerance. Higher risk will result in higher returns. This doesn’t mean you should always aim for the higher risk. You don’t need to make all the money in the world. Next time, when you are in a dilemma whether to take a risk or not, ask yourself two questions: