Question

Hi, can you answer this question in more detail?

Subject: Hong Kong Personal Financial Planning Practice

Q3. C

The relationship between investment risk and potential return is positive. Analyze the risks of investment and the returns from investment.

(Words: 700 - Don't direct copy)

Answer 1

Risk and Return

In investing, risk and return are highly correlated. Increased potential returns on investment usually go hand-in-hand with increased risk. Different types of risks include project-specific risk, industry-specific risk, competitive risk, international risk, and market risk. Return refers to either gains and losses made from trading a security.

The return on an investment is expressed as a percentage and considered a random variable that takes any value within a given range. Several factors influence the type of returns that investors can expect from trading in the markets.

Diversification allows investors to reduce the overall risk associated with their portfolio but may limit potential returns. Making investments in only one market sector may, if that sector significantly outperforms the overall market, generate superior returns, but should the sector decline then you may experience lower returns than could have been achieved with a broadly diversified portfolio.

investment risk

Investment risk refers to the level of volatility, or fluctuation in investment, returns, you're prepared to accept.

The word 'risk' has a number of connotations with regards to investment, however there are three main risk factors to consider:

• The risk of losing your initial investment – for example, if you invested in a company which is poorly managed and subsequently went bankrupt, you could lose your total investment. This is a rare occurrence, however, cases such as Enron show that there is some possibility of this occurring.
• The risk of receiving a lower than expected growth return – for example, the value of an asset in which you have invested, such as a house or shares, either increases at a lower than expected rate or even decreases when you were expecting growth.
• The risk of receiving a lower than expected income return – for example, if you purchased shares and expected a dividend payout of 50 cents per share and you only received 10 cents per share.

As discussed previously, the type of risks you are exposed to will be determined by the type of assets in which you choose to invest. Fixed interest and cash investments will generally be low risk (defensive assets) and assets such as property and shares are generally considered to be high risk (growth assets).

What's the relationship between risk and return?

Whilst we would all love to find a perfect investment which has low risk and high returns, the fact is that this doesn't exist because risk and return are positively related.

This means that the lower risk investments – while good for peace of mind – will generally provide a lower long-term return than a high risk investment.

How Diversification Reduces or Eliminates Firm-Specific Risk

First, each investment in a diversified portfolio represents only a small percentage of that portfolio. Thus, any risk that increases or reduces the value of that particular investment or group of investments will only have a small impact on the overall portfolio.

Second, the effects of firm-specific actions on the prices of individual assets in a portfolio can be either positive or negative for each asset for any period. Thus, in large portfolios, it can be reasonably argued that positive and negative factors will average out so as not to affect the overall risk level of the total portfolio.