The term "risk and return" refers to the potential financial loss or gain experienced through investments in securities.

An investor who has registered a profit is said to have seen a "return" on his or her investment. The "risk" of the investment, meanwhile, denotes the possibility or likelihood that the investor could lose money. If an investor decides to invest in a security that has a relatively low risk, the potential return on that investment is typically fairly small. Conversely, an investment in a security that has a high risk factor also has the potential to garner higher returns. Return on investment can be measured by nominal rate or real rate (money earned after the impact of inflation has been figured into the value of the investment). Different securitiesincluding common stocks, corporate bonds, government bonds, and Treasury billsoffer varying rates of risk and return. As Richard Brealey and Stewart Myers noted in their book Principles of Corporate Finance, "Treasury bills are about as safe an investment as you can get. There is no risk of default and their short maturity means that the prices of Treasury bills are relatively stable." Long-term government bonds, on the other hand, experience price fluctuations in accordance with changes in the nation's interest rates. Bond prices fall when interest rates rise, but they rise when interest rates drop. Government bonds typically offer a slightly higher rate of return than Treasury bills. Another type of security is corporate bonds. Those who invest in corporate bonds have the potential to enjoy a higher return on their investment than those who stay with government bonds. The greater potential benefits, however, are available because the risk is greater. "Investors know that there is a risk of default when they buy a corporate bond," commented Brealey and Myers. Those corporations that have this default option, though, "sell at lower prices and therefore higher yields than government bonds." In the meantime, investors "still want to make sure that the company plays fair. They don't want it to gamble with their money or to take any other unreasonable risks. Therefore, the bond agreement includes a number of restrictive covenants to prevent the company from purposely increasing the value of its default option." Investors can also put their money into common stock. Common stockholders are the owners of a corporation in a sense, for they have ultimate control of the company. Their voteseither in person or by proxyon appointments to the corporation's board of directors and other business matters often determine the company's direction. Common stock carries greater risks than other types of securities, but can also prove extremely profitable. Earnings or loss of money from common stock is determined by the rise or fall in the stock price of the company. There are other types of company stock offerings as well. Companies sometimes issue preferred stock to investors. While owners of preferred stock do not typically have full voting rights in the company, no dividends can be paid on the common stock until after the preferred dividends are paid.

RISK AND RISK AVERSION

Many types of risk loom for investors hoping to see a return on their money, noted Jae K. Shim and Joel G. Siegel in their Handbook of Financial Analysis, Forecasting, & Modeling. Business risk refers to the financial impact of basic operations of the company. Earnings variables in this area include product demand, selling price, and cost. Liquidity risk is the possibility that an asset

may not be sold for its market value on short notice, while default risk is the risk that a borrower company will be unable to pay all obligations associated with a debt. Market risk alludes to the impact that market-wide trends can have on individual stock prices, while interest rate risk concerns the fluctuation in the value of the asset as a result of changes in interest rate, capital market, and money market conditions. Individual risk aversion is thus a significant factor in the dynamics of risk and return. Cautious investors naturally turn to low-risk options such as Treasury bills or government bonds, while bolder investors often investigate securities that have the potential to generate significant returns on their investment. Certain types of common stock that fit this description include speculative stocks and penny stocks. Many factors can determine the degree to which an investor is risk-averse. William Riley and K. Victor Chow contended in Financial Analysts Journal that "relative risk aversion decreases as one rises above the poverty level and decreases significantly for the very wealthy. It also decreases with agebut only up to a point. After age 65 (retirement), risk aversion increases with age." Riley and Chow note that decreases in risk aversion often parallel higher degrees of education as well, but speculate that "education, income and wealth are all highly correlated, so the relationship may be a function of wealth rather than education." Economically disadvantaged families are, on the surface, often seen as risk-averse; in actuality, however, decisions by these households to avoid investment risk can be traced to a lack of discretionary income or wealth, rather than any true aversion. As Riley and Chow noted, "risk aversion can be expected to decrease as an individual's wealth increases, independent of income. Someone whose stock of wealth is growing can be expected to become less risk-averse, as her tolerance of downside risk increases."

Risk and Return Analysis

Return expresses the amount which an investor actually earned on an investment during a certain period. Return includes the interest, dividend and capital gains; while risk represents the uncertainty associated with a particular task. In financial terms, risk is the chance or probability that a certain investment may or may not deliver the actual/expected returns.

The risk and return trade off says that the potential return rises with an increase in risk. It is important for an investor to decide on a balance between the desire for the lowest possible risk and highest possible return.

Risk Analysis
Risk in investment exists because of the inability to make perfect or accurate forecasts. Risk in investment is defined as the variability that is likely to occur in future cash flows from an investment. The greater variability of these cash flows indicates greater risk. Variance or standard deviation measures the deviation about expected cash flows of each of the possible cash flows and is known as the absolute measure of risk; while co-efficient of variation is a relative measure of risk. For carrying out risk analysis, following methods are used

Payback [How long will it take to recover the investment] Certainty equivalent [The amount that will certainly come to you] Risk adjusted discount rate [Present value i.e. PV of future inflows with discount rate]

However in practice, sensitivity analysis and conservative forecast techniques being simpler and easier to handle, are used for risk analysis. Sensitivity analysis [a variation of break even analysis] allows estimating the impact of change in the behavior of critical variables on the investment cash flows. Conservative forecasts include using short payback or higher discount rates for discounting cash flows. Investment Risks Investment risk is related to the probability of earning a low or negative actual return as compared to the return that is estimated. There are 2 types of investments risks:
1. Stand-alone risk

This risk is associated with a single asset, meaning that the risk will cease to exist if that particular asset is not held. The impact of stand alone risk can be mitigated by diversifying the portfolio. Stand-alone risk = Market risk + Firm specific risk Where,
Market risk is a portion of the security's stand-alone risk that cannot be eliminated trough diversification and it is measured by beta o Firm risk is a portion of a security's stand-alone risk that can be eliminated through proper diversification 2. Portfolio risk
o

This is the risk involved in a certain combination of assets in a portfolio which fails to deliver the overall objective of the portfolio. Risk can be minimized but cannot be eliminated, whether the portfolio is balanced or not. A balanced portfolio reduces risk while a non-balanced portfolio increases risk. Sources of risks
o o o o o o

Inflation Business cycle Interest rates Management Business risk Financial risk

Return Analysis
An investment is the current commitment of funds done in the expectation of earning greater amount in future. Returns are subject to uncertainty or variance Longer the period of investment, greater will be the returns sought. An investor will also like to ensure that the returns are greater than the rate of inflation. An investor will look forward to getting compensated by way of an expected return based on 3 factors

Risk involved Duration of investment [Time value of money] Expected price levels [Inflation]

The basic rate or time value of money is the real risk free rate [RRFR] which is free of any risk premium and inflation. This rate generally remains stable; but in the long run there could be gradual changes in the RRFR depending upon factors such as consumption trends, economic growth and openness of the economy. If we include the component of inflation into the RRFR without the risk premium, such a return will be known as nominal risk free rate [NRFR] NRFR = ( 1 + RRFR ) * ( 1 + expected rate of inflation ) - 1 Third component is the risk premium that represents all kinds of uncertainties and is calculated as follows Expected return = NRFR + Risk premium Risk and return trade off

Investors make investment with the objective of earning some tangible benefit. This benefit in financial terminology is termed as return and is a reward for taking a specified amount of risk. Risk is defined as the possibility of the actual return being different from the expected return on an investment over the period of investment. Low risk leads to low returns. For instance, incase of government securities, while the rate of return is low, the risk of defaulting is also low. High risks lead to higher potential returns, but may also lead to higher losses. Long-term returns on stocks are much higher than the returns on Government securities, but the risk of losing money is also higher. Rate of return on an investment cal be calculated using the following formulaReturn = (Amount received - Amount invested) / Amount invested He risk and return trade off says that the potential rises with an increase in risk. An investor must decide a balance between the desire for the lowest possible risk and highest possible return.