When it comes to investments, two concepts go hand-in-hand, risk and return. It is because both of these are mostly related to and impact each other. Every time an investor includes new investments in their portfolios, they consider the risks and returns on the investment. Therefore, it is crucial to understand what each of these concepts is and what they represent.
What is Risk in investment?
Risks in investment represent the probability or uncertainty of losses. When investing, investors want to maximize their returns. Therefore, they look for investments that can make the highest amount of profits. However, investments don’t only come with profits. There is a chance they might result in losses as well. The possibilities of those losses occurring or realizing represent the risk of the investment.
There are many reasons why investors may consider specific investments risky. These reasons may include market conditions, uncertainties, the timing of investment, etc. Therefore, according to the source or type of risk, investors consider different risks for an investment. These may include market risk, liquidity risk, longevity risk, inflation risk, credit risk, etc.
What is Return on investment?
Returns represent the profits that investors get on their investment, usually annually. Sometimes, returns may also come semi-annually or quarterly. Similar to the risks of an investment, its returns are not predetermined. Therefore, investors use different tools to predict or forecast the returns they will receive on their investments. To do so, they use historical information from their investment.
There are various types of returns that investors can get on their investments based on several factors. For example, investors can benefit from capital gains or dividends from investing in stocks. On the other hand, capital gains may not be an option when it comes to returns on bonds or debts. Apart from these, other factors also influence returns, including the risk of investments.
How are they related?
The relationship between risk and return is straightforward. While both may not be directly proportional, they are closely related. Usually, the higher the risks associated with an investment is, the higher its returns will be as well. Similarly, for lower-risk investments, the returns will also be comparatively lower.
As stated above, investors always aim to maximize their returns. However, they also prefer lower risks. Nevertheless, both of them contradict each other. Therefore, investors always try to strike a balance between the two. However, depending on the risk tolerance of investors, they may go to either end. Hence, investors can use other techniques to minimize their risks while also getting a respectable return.
The most common way in which investors minimize their risks is through diversification. Diversification does not eliminate specific risk, which relates to each investment. However, it can eliminate systematic risk. Regardless of which technique investors use, there always will be a relationship between risk and returns.
There are two factors that investors consider when deciding on additions to their portfolios. These are the risks and returns of the investment. Risks represent the probability of losses on an investment. On the other hand, returns represent the profits that investors will make on their investment. Both of these are highly related to or depend on each other.