Question

As a financial leader of your organization, how would you apply the concept of risk and return in the decision-making process? How you are going to explain the risk vs. return trade-off during the shareholders meeting?

Answer 1

The concept of risk and return goes hand in hand.While investor like return they abhor risk. Every investment decision involve a tradeoff between risk and return.Since, the risk and return are central to investment decisions, we must understand what risk and return and how they should be measured.

The return of an investment consists of two components.The first is current return and second is capital return. Current return is the periodic income such as dividend or interest in relation to the beginning price of the investment.Capital return is the price appreciation or depreciation divided by the beginning price of the asset.So, we can measure total return on any investment is as follow:

Total return = Current return + Capital return

Total return = Cash payment received during the period / Beginning price + Capital appreciation/ depreciation / Beginning price

Total return = ( Cash payment receive during the period + price change over the period) / Beginning price

Risk is the possibility that actual outcome of an investment will differ from its expected outcome.The wider the range of possible outcome, the greater the risk. Risks are of two type. First is unique risk and second is market risk. Unique risk is arise due to firm-specific factors like development of a new product, a labor strike, or the emergence of a new competitor.Unique risk are also called diversifiable risk or unsystematic risk.Market risk is attributable to economy-wide factors like growth rate of GDP, the level of government spending,money supply, interest rate structure and inflation rate. Market risk are also called systematic risk or non-diversifiable risk. Total risk can be measured by variance and standard deviation analysis.

Every investment decision involve a tradeoff between risk and return. If we assume low risk, then our potential return will be low and if we assume high risk, then our potential return will be high. The risk and return tradeoff is nothing but, just a balance approach between lowest possible risk and higher possible return on the investment. It can achieve by diversification. Diversification is a risk- management technique that mixes a wide variety of investments with in a portfolio in order to minimize the risk that any one security will have on the overall performance of the portfolio.