Understanding Risk and Return in Investing

In investing, risk and return are highly correlated. Increased potential returns on investment usually go hand-in-hand with increased risk. Different types of risks include project-specific risk, industry-specific risk, competitive risk, international risk, and market risk. Return refers to either gains and losses made from trading a security.

The return on an investment is expressed as a percentage and considered a random variable that takes any value within a given range. Several factors influence the type of returns that investors can expect from trading in the markets.

Diversification allows investors to reduce the overall risk associated with their portfolio but may limit potential returns. Making investments in only one market sector may, if that sector significantly outperforms the overall market, generate superior returns, but should the sector decline then you may experience lower returns than could have been achieved with a broadly diversified portfolio.

How Diversification Reduces or Eliminates Firm-Specific Risk

First, each investment in a diversified portfolio Capital Allocation Line (CAL) and Optimal PortfolioStep by step guide to constructing the portfolio frontier and capital allocation line (CAL). The Capital Allocation Line (CAL) is a line that graphically depicts the risk-and-reward profile of risky assets, and can be used to find the optimal portfolio.represents only a small percentage of that portfolio. Thus, any risk that increases or reduces the value of that particular investment or group of investments will only have a small impact on the overall portfolio.

Second, the effects of firm-specific actions on the prices of individual assets StockWhat is a stock? An individual who owns stock in a company is called a shareholder and is eligible to claim part of the company’s residual assets and earnings (should the company ever be dissolved). The terms "stock", "shares", and "equity" are used interchangeably.in a portfolio can be either positive or negative for each asset for any period. Thus, in large portfolios, it can be reasonably argued that positive and negative factors will average out so as not to affect the overall risk level of the total portfolio.

The benefits of diversification can also be shown mathematically:

σ^2portfolio= WA^2σA^2 + WB^2σB^2 + 2WA WBр ABσ AσB

Where:

σ = standard deviation

W = weight of the investment

A = asset A

B = asset B

р = covariance

Other things remaining equal, the higher the correlation in returns between two assets, the smaller are the potential benefits from diversification.

Comparative Analysis of Risk and Return Models

• The Capital Asset Pricing Model (CAPM)Capital Asset Pricing Model (CAPM)The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between expected return and risk of a security. CAPM formula shows the return of a security is equal to the risk-free return plus a risk premium, based on the beta of that security
• APM
• Multifactor model
• Proxy models
• Accounting and debt-based models

For investments with equity risk, the risk is best measured by looking at the variance of actual returns around the expected return. In the CAPMCapital Asset Pricing Model (CAPM)The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between expected return and risk of a security. CAPM formula shows the return of a security is equal to the risk-free return plus a risk premium, based on the beta of that security, exposure to market risk is measured by a market beta. The APM and the multifactor model allow for examining multiple sources of market risk and estimate betas for an investment relative to each source. Regression or proxy model for risk looks for firm characteristics, such as size, that have been correlated with high returns in the past and uses them to measure market risk.

On investments with default risk, the risk is measured by the likelihood that the promised cash flows might not be delivered. Investments with higher default risk usually charge higher interest rates, and the premium that we demand over a riskless rate is called the default premium. Even in the absence of ratings, interest rates will include a default premium that reflects the lenders’ assessments of default risk. These default risk-adjusted interest rates represent the cost of borrowing or debt for a business.

Related Readings

• Investing: A Beginner’s GuideInvesting: A Beginner's GuideCFI's Investing for Beginners guide will teach you the basics of investing and how to get started. Learn about different strategies and techniques for trading
• Market Risk PremiumMarket Risk PremiumThe market risk premium is the additional return an investor expects from holding a risky market portfolio instead of risk-free assets.
• Basis RiskBasis RiskBasis risk is the risk that the futures price might not move in normal, steady correlation with the price of the underlying asset, so as to negate the effectiveness of a hedging strategy in minimizing a trader's exposure to potential loss. Basis risk is accepted in an attempt to hedge away price risk.
• Expected ReturnExpected ReturnThe expected return on an investment is the expected value of the probability distribution of possible returns it can provide to investors. The return on the investment is an unknown variable that has different values associated with different probabilities.