Risk and Return¶
Risk¶
Risk refers to the uncertainty associated with the potential for loss or the lack of capital appreciation. It is important to distinguish between risk and uncertainty:
- Risk: A condition where a decision-maker has knowledge of the possible outcomes of his decisions.
- Uncertainty: A situation where the outcomes of decisions are unknown, and the probabilities of occurrences can't be predicted.
- Risk in Finance: In the context of finance, risk can be present even in situations where income is certain or uncertain.
Return¶
Investors seek a return on their investments, which may come in the form of interest, dividends, or capital appreciation.
- Realized Return: The actual income earned from past investments.
- Expected Return: The anticipated income from investments, which may or may not be realized, thus introducing the concept of investment risk.
Risk-Return Tradeoff¶
The variability of returns can lead to uncertainty, loss of income, capital losses, or erosion of the real value of income and wealth. Generally, a higher level of risk is associated with the potential for higher returns.
Factors Affecting Risks¶
Several factors can influence the level of risk associated with an investment:
- Decision-making errors by the investor.
- Timing of investments.
- The nature of the investment, such as the category of assets.
- The creditworthiness of the issuer, for example, government securities.
- The maturity period of the investment.
- The amount of investment.
- The method of investment.
- The terms of lending.
- The nature of the industry or business.
- National and international economic and political factors.
Understanding the balance between risk and return is crucial for investors in making informed decisions that align with their investment goals and risk tolerance.
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