Define risk and explain its relationship to reward

The Relationship Between Risk and Reward | InvestorsFriend

define risk and explain its relationship to reward

Risk and reward go hand-in-hand with investing in financial markets. Learn about this relationship and how you can make it work for you. which means you should not worry about the amount of risk in your portfolio so much. An entrepreneur cannot avoid risk in a start-up and everyone knows that a large proportion of new businesses So, a calculated risk can be defined as follows. The risk–return spectrum is the relationship between the amount of return gained on an Please help improve it or discuss these issues on the talk page. There is considerable overlap of the ranges for each investment class. . this means that the highest-risk investment has the highest Sharpe Ratio and so dominates.

And calculations of beta vary dramatically depending if one works with monthly, daily, weekly or annual returns. And if one believes that diversifiable risks are also relevant then it is clear that those cannot be so easily measured. How can you measure the chance that completely random events will occur? In addition some investors are not so concerned about volatility but are much more concerned about the risk that their long term wealth will be below an acceptable level.

Short term volatility does not address very well the risk of long term purchasing power. For example treasury bills are not risky in the short term but putting all funds into Treasury bills would cause a large risk of insufficient long term purchasing power, as the returns barely keep up with inflation.

define risk and explain its relationship to reward

My belief is that at best we can get a rough qualitative sense of the risk but we cannot precisely measure it. I also believe that their is too much focus on short term volatility and not enough focus on the risk of long term real after inflation wealth risk. Risk Fallacy Number 4: Well, they might all be market returns but they are not equivalent in any sense.

And there is some small chance that even over many years the risk free rate will actually turn out to beat the market return. A mythical average investor might be indifferent to the two positions along the SML.

I may choose the safe route and expect a lower return.

What is risk/reward tradeoff? definition and meaning -

You may choose to take a maximum amount of risk and its expected far superior return. There is nothing equivalent about this. The further away from perfect the credit rating, the higher up the risk-return spectrum that particular investment will be.

Mid- and long-term loans to blue-chip corporations[ edit ] Overlapping the range for short-term debt is the longer term debt from those same well-rated corporations.

These are higher up the range because the maturity has increased.

define risk and explain its relationship to reward

The overlap occurs of the mid-term debt of the best rated corporations with the short-term debt of the nearly perfectly, but not perfectly rated corporations. In this arena, the debts are called investment grade by the rating agencies.

define risk and explain its relationship to reward

The lower the credit rating, the higher the yield and thus the expected return. Rental property[ edit ] A commercial property that the investor rents out is comparable in risk or return to a low-investment grade.

Industrial property has higher risk and returns, followed by residential with the possible exception of the investor's own home. High-yield debt[ edit ] After the returns upon all classes of investment-grade debt come the returns on speculative-grade high-yield debt also known derisively as junk bonds. These may come from mid and low rated corporations, and less politically stable governments.

Equity[ edit ] Equity returns are the profits earned by businesses after interest and tax.

define risk and explain its relationship to reward

Even the equity returns on the highest rated corporations are notably risky. Small-cap stocks are generally riskier than large-cap ; companies that primarily service governments, or provide basic consumer goods such as food or utilities, tend to be less volatile than those in other industries. Note that since stocks tend to rise when corporate bonds fall and vice versa, a portfolio containing a small percentage of stocks can be less risky than one containing only debts.

Options and futures[ edit ] Option and futures contracts often provide leverage on underlying stocks, bonds or commodities; this increases the returns but also the risks.

Note that in some cases, derivatives can be used to hedgedecreasing the overall risk of the portfolio due to negative correlation with other investments.

risk/reward tradeoff

For example, the more risky the investment the more time and effort is usually required to obtain information about it and monitor its progress.

For another, the importance of a loss of X amount of value is greater than the importance of a gain of X amount of value, so a riskier investment will attract a higher risk premium even if the forecast return is the same as upon a less risky investment.

May also be called a investor. But if the company is successful, you could see higher dividends and a rising shareShare A piece of ownership in a company. But it does let you get a share of profits if the company pays dividends. Some investments, such as those sold on the exempt market are highly speculative and very risky. They should only be purchased by investors who can afford to lose all of the money they have invested. DiversificationDiversification A way of spreading investment risk by by choosing a mix of investments.

The idea is that some investments will do well at times when others are not.

define risk and explain its relationship to reward

May include stocks, bonds and mutual funds. The equity premium Treasury bills issued by the Canadian government are so safe that they are considered to be virtually risk-free. The government is unlikely to default on its debtDebt Money that you have borrowed. You must repay the loan, with interest, by a set date.