Measure the volatility
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. In fact, this risk premium is the compensation for investors
to accept that level of volatility.
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.
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