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Explain The Relationship Between Risk and Return

Risk refers to the potential for unfavorable outcomes when making an investment, while return is what is earned on an investment. Generally, higher risk investments like stocks offer potentially higher returns than lower risk ones like treasury bills. Diversification reduces risk by allocating investments across different asset classes that may react differently to market changes, allowing returns to be stabilized without necessarily lowering potential gains.

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Kristine Claire Pangandoyon
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168 views

Explain The Relationship Between Risk and Return

Risk refers to the potential for unfavorable outcomes when making an investment, while return is what is earned on an investment. Generally, higher risk investments like stocks offer potentially higher returns than lower risk ones like treasury bills. Diversification reduces risk by allocating investments across different asset classes that may react differently to market changes, allowing returns to be stabilized without necessarily lowering potential gains.

Uploaded by

Kristine Claire Pangandoyon
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Explain the relationship between risk and return.

Explain the relationship between risk and return.

Risk refers to the chance that some unfavorable event will occur . It is the
degree of unpredictability and/or potential financial loss that goes along with making
an investment choice. Return, on the other hand, is what is earned on an investment.
It measures the gain or loss of an investment. Risk and return are positively or
directly correlated with each other. As a general rule, the higher the risk, the higher
the return and the lower the risk, the lower the return. However, there is no
guarantee that increasing your risk will always yield a higher return because it could
also result in a greater loss of capital or amount.

Example situation “The higher the risk, the higher the return”.

For instance, when you invest in stocks, you take on more risk than investing
in bonds or treasury bills because the dividends you receive in stocks depend on the
profitability of the company in which you invested the stocks. There is no guarantee
that you will get a return on your investment every year. Stocks are considered the
riskiest investment because if the company fails, the entire investment will be lost.
However, if the company does well, stocks will definitely give you a better return on
your investment, as they offer the highest return rates compared to bonds and
Treasury bills.

Example situation “the lower the risk, the lower the return”.

On the other hand, if you invest in treasury bills, which have the lowest risk
among stocks and bonds, you will receive lower returns than if you invested in stocks
or bonds. Treasury bills are considered a good retirement investment since it is a
safe investment given that it is low risk due to the assumption that the government is
always solvent and can always pay its debt, thus the return on your investment is
guaranteed.
Discuss how diversification allows you to reduce the risk on your portfolio
without sacrificing potential returns.

Importance of diversification

Diversification is important because it is a risk-reduction strategy that


allocates investments among different financial instruments, industries, and other
categories. It seeks to maximize return by investing in various areas, each of which
should react differently to changes in market conditions.Investors use diversification
to reduce the impact of market volatility on their portfolio. Diversification is based on
the idea that different asset classes will react differently to the same market event,
and thus when one asset underperforms, the impact will be limited by those assets
that perform well.

How it reduces the risk on your portfolio without sacrificing potential returns.

As we all know already, owning too much of an individual stock gives us


higher volatility because if that single stock declines then we have no fallback plan
that will stabilize it. However, there is a safer way of investing which is through using
diversification. Diversification gives you a weighted average return on the various
assets that you own. A well-diversified portfolio will have a limited fall in case of
inflation or deflation of some stocks, as the other stocks that you own may balance
out what you have lost. Furthermore, adding more assets to the risk of a portfolio will
result in eliminating the unsystematic risks, thus leaving us with systematic risk
which shows us how a group of assets move together. Moreover, this gives you a
smoother and potentially better return.

Give example of diversification

There are numerous diversification techniques that one may employ. One
example is the development of new models for a similar product by a specific
company. This can broaden consumers' options and reduce the likelihood of the
company failing since creating multiple models increases the probability of
generating sales. Another example would be investing in multiple stocks rather than
just one. Stocks are also volatile, and it is risky to devote all of your resources to a
single one because its value can plummet in a single blow. It is safer to invest in
multiple stocks because it gives us higher chances of gains and reduces the risks of
loss.

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