Return and risk

1.5

Defining Risk

• Risk refers to the chance that some unfavorable event will happen

• Investment risk is the probability that actual returns may deviate from expected returns

• The chance that actual returns may be lower than expected return gives rise to investment risk

• Higher the probability of actual returns being less than expected, higher will be investment risk

Returns

• Actual Return– Realized return/historical return/return ex-post

• Expected Return– Return ex-ante/anticipated return– A weighted average of all possible returns,

where weights represent probability of each possible outcome

– Multiply each possible outcome with its probability and add them up over all possible outcomes

The Risks and Rewards of InvestingRISKS of Investing!

BusinessFinancialMarketPurchasing PowerInterest RateLiquidityEvent

Risks and Rewards of Investing

• Historically, there has been a relationship between risk and return for most investments - - the higher the risk, the greater the potential return.

• However, in the short-run, higher risk means greater potential variability in returns including the loss of a portion or all of your original investment.

The Risk-Return Relationship

Risk

Return Treasury Bills

Bonds

Common Stock

Real Estate Options

Commodities andFinancial Futures

PreciousMetals

Low risk investments tend to offer lower returns.

Returns from Investing

• Investments offer two potential sources of return to investors– Current income, and– Capital gains

• Fixed-income securities like bonds offer:– Interest, and– Capital gains

• Common stock investments offer:– Dividends, and– Capital gains