Risk and return are fundamental to investing. The two ideas form the basis of all decisions and will weigh heavily on the choices you make. Every investment will have both risk and return attached to it in some way. You should take your time to appreciate how risk and return work, the relationship between the two and how it will be important for your investing future. Understanding risk and return and using that knowledge can you help to success on your investing journey.
What is Investment Return
In finance, return is defined as the money gained (or lost) on an asset. When you invest, return is the amount of money you receive from the investment you have made. This could either be through a change in the value or received cash flows from the asset.
Investment return can be calculated directly in a cash figure or can be converted to a percentage or ratio. This allows return to be measured and compared, to understand the performance of investments over a period of time. Returns can be historical or expected. Historical returns are the those based on past data which have occurred, whereas expected returns are the returns which are predicted to occur.
The ideal situation is to make a profit – positive gains on your investment. However, there is no guarantee and you could make a loss (a negative return). Every investment will have a different return, as there are a number of factors which can affect how an investment performs.
What is Investment Risk
Investment risk is the uncertainty of financial returns from an asset. Risk considers the probability of lower returns and the possibility of losses. It is the idea that the real return will be different from what the return was expected to be.
When investing in an asset, there is always the possibility of something going wrong. Risk takes into consideration the unpredictability about an investment’s returns and the implications that can cause investments to have lower than expected returns.
Each asset has a different level of risk, from low to high. The type of asset, the nature of the asset and the types of risk each asset is exposed to will affect its level of risk. The aim is to minimise risk as much as possible to ensure returns can be as close to expected as possible. When investing, risk will be one of, if not the major factor in choosing assets.
What is the relationship between risk and return?
Risk and return work together in all situations of life, and when investing, it is no different. Whenever you invest your money, there is both risk and return involved. They are directly related as you can’t have one without the other.
As you invest, you will have an idea of returns you wish to make. However, those returns can’t come at any price. This is because there is investment risk which affects those returns.
The relationship between risk and return is simply the amount gained on an investment in comparison to the amount of risk taken on in the investment. When you invest, there is essentially a trade-off between risk and return in which it is suggested that risk correlates directly with return. The greater the level of risk you take on, the greater returns could potentially be. However, there is no guarantee and returns differ with varying levels of risk. The level of risk does not equal returns.
Within the spectrum, every investor will have a different level of adversity to risk. Some may be willing to take on large amounts of risk, whilst others may wish to be much safer with the investments they choose. The returns desired will differ too. It means investors will take on appropriate levels of risk to aim for the returns they wish to try and achieve. Therefore, it is important investors are able to find a balance between the risk of an investment and its potential return.
Why risk and return is important to investors
Understanding risk and return and the relationship between the two is central to the investment choices you make. As every investment takes into account both risk and return, you need to know how they work in order to find the right balance for you.
When you consider your investments, it is key you understand the returns you wish to make. It allows you to set appropriate goals and choose the type of investments you can make to try and achieve those returns. However, and perhaps most importantly, is the need to understand risk and how it will affect you and the returns you make. Risk is key to what you want to achieve.
Having that understanding of the two ideas enables you to invest using risk and return. When you do invest, you will consider the situation and weigh up the options. It allows you to decide whether the investment is worth it based on the risk and the potential returns that come with it. Therefore, risk and return are key components to the investments you choose, which is why they are so important to your investing journey.