Day 99

The risk and return

The risk and returns are probably the most common concepts acknowledged by financial decision makers. These two factors are contrary evaluations but work mutually on the assessment of financial assets. As a matter of fact, the trade-off between risk and return would normally reflect a positive pattern. Where the riskier the investment is, the higher return can be expected by the investor to receive. Hence it is the fundamental knowledge for financial participants on balancing the risk and return over a financial asset.

So how do we define the term ‘ risk’ in finance? In my opinion, the risk is the uncertain difference between the expected outcome and the actual result. It should be the deviation that diversifies the output. The risk itself must be uncertain, has a considerable impact over the outcome and may generate either positive or negative effect. Therefore, it is crucial for financial decision-makers to understand the actual influences of the risk. People may react differently corresponding to the severity of the risk. Generally, all of us are risk averse, since no one would prefer to lose control on the outcome. However, the correlative better return induced many groups to be risk takers. For instance, the average real return for the 10-year bond during 1999 to 2009 was 4.43%. On the other hand, the mean return on share market investment provided by the All Ords index was 9.95%. Thus that risk premium at 5.67% was sufficient for many financial participants to take the risk.

After the explanations of risk, the tricky part is how do we ‘hedging’ it with the return in order to achieve the maximum efficiency on our fund's utilization? It involves the study of statistics. We should calculate the standard deviation on the return, and consequently, we will be able to identify the extent of the possible return. For example, there are 68% of probability that the actual return will occur between the sectors of expected return plus/minus the standard deviation value. The investors can easily observe the possible return distribution, thereby the measurement over risk and return will be amplified for following decisions.

Although the higher risk may lead to better gain on investment, we need to balance between them so un-anticipated loss can be avoided.