Running Head: RISK AND RETURNS 1 Week four Journal: The importance of the risk and return balance Name BUS 401 Principles of Finance Instructor James York July 15, 2013 RISK AND RETURNS 2 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 RISK AND RETURNS 3 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 RISK AND RETURNS 4 are rewarded for taking on this type of risk. In short, only systematic risk determines the expected rate of return for a security (share or bond). (Hickman, K.A., Byrd, J. W. & McPherson, M., 2013) If you take on a large risk, are you guaranteed a large return? Why or why not? Taking a large risk does not in any way guarantee that that the investment will yield a large return. There are various factors that help in illustrating this perspective. Firstly, there is always the risk that an investment will yield no returns. While this is an extreme occurrence, the investor should not overrule it. For instance, the modern investment market is characterized by extensive levels of uncertainty. Due to such uncertainty, a large risk does not always guarantee a large return. There are numerous variables affecting the return obtained from an investment. The implications of these variables are more les independent on the amount of risk for that investment. Due to such variability, large risk does not always form the basis of large returns (Chance & Brooks, 2009). But it is important to remember that this does not mean you will automatically obtain a high return just by taking sufficient risk. It is fundamentally pertinent to outline that large risk implies that there is a high likelihood that the investor will not yield any return from the investment. For instance, a large risk in the shares of a company implies that there is great possibility that the company will make losses. When such losses occur, it is significantly challenging to obtain any return. Large risk might also imply that an investment is subject to an extensive degree of market volatility. In such investments, the investor can easily lose the money directed to such a portfolio. (Chance & Brooks, 2009) This is another perspective that indicates that large risks are not RISK AND RETURNS 5 directly proportional to large returns. Even when the risk of an investment is low, the return might be large. Consequently, investors should not always target the investments that have a large risk. There is no guarantee that taking on a large risk, means that you guaranteed a large return. If the return varies substantially from period to period we say that the total risk is high, while a low total risk means small variations. The most common way to measure risk is to calculate how strongly the returns from an investment vary between periods. If the fluctuations are large, your savings could be worth much more than today, but it is also not possible to rule out a decrease in value. What other factors play into risks that are not covered in the video? Legal Risks: Changes in tax laws and industry regulations can eat into small businesses’ profit margins. Companies might find themselves unable to meet debt obligations due to large unforeseen expenses, such as the mandatory installation of new safety systems or a hefty tax on carbon emissions. New laws can even push companies out of business entirely, such as when popular pharmaceuticals or food products are banned by a government authority. Economic Risks: Companies are exposed to financial risk from various aspects of the overall economy. Weakness in the economy, specific markets, industries or demographic groups can cause sudden drops in demand for particular goods or services, leaving small businesses with less money than they had anticipated. Negative shifts in demand can cause prices to drop across entire industries, putting all businesses at risk by quickly lowering profit margins and weakening income statements. Economic risk factors are uncontrollable from within an organization. (Amacher, R., & Pate, J. 2013). RISK AND RETURNS 6 Performance Risks: The risk of failure cannot be discounted when considering financial risk factors. Sole proprietors take on personal liability for all company financing; if the company closes its doors, the business owner can find himself in serious financial trouble, possibly resulting in personal bankruptcy. (Walter, 2012) The risk of failure is an ever-present reality that entrepreneurs must face with confidence and caution. Aside from outright failure, a company’s income statements may turn out weaker than expected in a given quarter or year, leaving it with less money to repay debts, and weaker valuations to show to lenders. A number of factors can cause weaker-than-expected performance; new competition, quality issues and ineffective planning are just a few. Risk and Return in Personal Decision Making From a personal perspective, there are various instances during which I have had to consider risk and return while making decisions. Two years ago, I had total savings of $2000. I intended to examine the most feasible investment for my savings. For the first option, I could buy chares is a blue-chip firm and sell them when the stock price increases. Alternatively, I could open a fixed deposit account and withdraw the money after five years. I analyzed the risk and return for each alternative in order to make the best decision from a financial perspective. I considered the first option as being too risky because of market uncertainties. Consequently, I opted to open a fix deposit account due to the minimal risk associated with such investments. RISK AND RETURNS 7 References Amacher, R., & Pate, J. (2013). Microeconomics Principles and Policies. San Diego, CA: Bridgepoint Education, Inc. Chance, D. M. & Brooks, R. D. (2009). An introduction to risk management, Mason, OH: Cengage Learning Hickman, K.A., Byrd, J. W. & McPherson, M. (2013). Essentials of finance. San Diego, CA: Bridgepoint Education Inc. Walther, (2012). Principles of Accounting: Volume I. San Diego, CA: Bridgepoint Education, Inc.