Increased Return for Risk Taken

Explaining Risk and Return

Return...

...is the amount that your investment provides at the end of a given period of time. For example, if you invest $100 and at the end of a year you have $110, your return is $10, or 10%.

Risk...

...refers to the extent to which an investment may vary in value over a given period of time. For example, consider the following possible company stocks:

	Stock Price of Company 1	Stock Price of Company 2
Monday	$100	$100
Tuesday	$150	$105
Wednesday	$50	$95
Thursday	$75	$97.50
Friday	$125	$102.50
Weekly Average Price	$100	$100

Both stocks have an average price over the week of $100. However, the stock price of Company 1 varies from a low of $50 to a high of $150. If a person went to sell that stock on a given day, she could receive a very high price ($150) or a very low price ($50) - it depends on the day of the week.

Thus, holding the stock of Company 1 implies a relatively high degree of uncertainty about the value of the stock on a given day. On the other hand, the stock of Company 2 has less variation in the price by day, with a low of $95 and a high of $105. The owner of that stock would have relatively less uncertainty about the price of the stock on a given day of the week.

We could say that the stock of Company 1 involves more “risk” than the stock of Company 2.

The Roles of Risk and Return in Investment

Now that we’ve defined the terms, let’s consider the roles of risk and return in investment. People invest because they expect to achieve a positive return. But all investment involves some degree of risk - investors are paid, in part, for their willingness to take on risk. In many cases, higher returns are in fact associated with a higher degree of risk. However, since risk involves uncertainty, investors generally look to reduce the degree of risk to the extent possible for a given return.

This idea underlies what we call the return-to-risk ratios or the number we get when dividing return by risk for a given period of time. A higher ratio means a better return for the degree of risk taken.