Investors have many options at their disposal in which to invest their money. Some put their money in the stock market while others prefer to invest their income in bonds and treasury bills. The investment option one opts to put their money in depends on their attitude towards risk; some are risk averse, some risk takers whereas some are risk neutral. The risk takers in most cases prefer putting their money where there is high risk but a high return potential as well. The risk averse on the other hand prefer putting their money in low-risk investments such as treasury bills and bonds or open up bank accounts and deposit their money where they will be guaranteed a specified amount of interest at the end of the month or year. The risk neutral, on the other hand, are not influenced by the risk element when making their investment decisions; they can put their money on either highly risky or low-risk ventures (Bali & Zhou, 2016). There is a close relationship between the risk associated with a particular investment and the expected return on that investment. The higher the risk associated with the investment, the higher the expected return and vice versa. This explains why people opt to put their money in risky ventures because they expect to earn a good return at the end of the investment period. There is no guarantee however that investing in risky ventures will yield impressive returns; at times people lose their whole investment in risky ventures.
To spread the risk associated with an investment, it is important that an investor diversifies his portfolio by investing in different options and using historical data to analyze the risk associated with their investment. At times managers will be faced with a situation where an investment decision that involves some degree of risk is involved, yet investing in such a project would imply that the overall risk exposure for the firm will be drastically reduced as it will have been diversified. In such cases, concerns that arise with regards to the overall risk of the firm have to be analyzed in view of the returns that are expected to be generated from the project to be undertaken. Return calculations give us a picture of whether an investment is good, average or just bad. Analysis of returns from the past gives us some trend of how the future will most likely look like (Sum, n.d.). In most cases, returns should be examined taking a long-term view rather than a short-term view as a one year return could be totally different than the cumulative returns for the past couple of decades.
The amount earned from an investment project can be determined using the actual dollar return or expressing the dollar return in terms of the amount of money invested in the project. The dollar return comprises of any profits (or losses) earned from a project as well as any other income earned. Total portfolio earnings will include a combination of profits (or loss) as well as dividends or interest income derived from the investment. It is usually affected by the market value of investments. Percentage return is popularly used to compare investment earnings as it allows for comparison of various investment returns with other alternative investment returns. Percentage return is computed by dividing the return earned by the investment value during the beginning of the time period. Percentage return can be used for any type of investment because it is highly standardized.
In cases where an investor has zero risk portfolio and intends to diversify the portfolio to include risky investments, the concept of average returns can be used to analyze returns over time. Average return gives an impression of how the portfolio has performed over longer periods of time and is mostly used for statistical analysis. The concept does not however accurately capture the historical performance of a portfolio, necessitating the use of geometric mean return instead.
The performance of different classes of portfolios fluctuates periodically. In a given year, the stock market might outperform the bond market, and in others, it performs worse. It is important to have a long-term view of how these classes of portfolios perform to guide investors on where to put their money. Stock market has historically been known to perform better than bond or cash markets (Bali & Zhou, 2016).
Investors who purchase U.S Treasury bills, for instance, are aware of what their dollar return is going to be. This is where risk averse individuals find comfort in, putting their money in this investment vehicle. However, for those who put their investment in the stock market, they are never sure of what their investment will earn them either in the short or long term (Bali & Zhou, 2016). This uncertainty is what makes the stock market very risky and a preferred destination only for the risk takers. It is, therefore, important that this uncertainty can be quantitatively assessed so as a comparison of different stock and asset classes can be done. According to precepts of financial theory, a historical analysis of an investments returns should be conducted to have an impression of the level of uncertainty associated with the investment in the future. An investment that displays high variability is a clear indicator that it is highly uncertain. The true measure of how volatile an investment portfolio is can accurately be ascertained using standard deviation. A greater standard deviation indicates a high risk associated with a portfolio.
Investors have a choice of either investing in risky ventures or zero risky ventures (Sum, n.d.). It would, however, be beneficial to ascertain how much an investor can reap by taking on extra risk, a phenomenon referred to as risk-return trade-off. The coefficient of variation is used to measure this risk-return trade-off. The coefficient of variation is described as the amount of risk per unit of return. Investors typically prefer a very high return associated with the lowest risk possible. This, therefore, implies that a smaller coefficient of variation is a better indicator of the risk-reward relationship.
Firms are faced with two different types of risk: specific and market risks. Specific risk is the inherent risk associated with the operations of a particular firm whereas market risk refers to those that face all the players in the industry. Standard deviation is a measure of total risk. Modern portfolio theory has been used to show how risk associated with investment can be reduced through diversification. It also proposes the concept of the optimal portfolio where different portfolios are combined to achieve the least risk possible for a certain expected return. Efficient portfolios are those that have the highest possible return for a given risk level.
Bali, T. & Zhou, H. (2016). Risk, Uncertainty, and Expected Returns. Journal Of Financial And Quantitative Analysis, 51(03), 707-735. http://dx.doi.org/10.1017/s0022109016000417
Sum, V. Analysis of Risk Premiums and Risk-Adjusted Excess Returns of the Best Companies to Work for in the United States. SSRN Electronic Journal. http://dx.doi.org/10.2139/ssrn.1950025
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