Risk and Return

The concept of risk and return relates to the potential financial gain or loss when investing in securities. A profit earned by an investor is termed a return on investment, while risk indicates the likelihood of losing money.
Risk and Return
3 min
20-July-2024
Investing money involves considering two main factors: risk and return. Risk is the chance that something might go wrong, leading to a loss of money. For example, investing in a risky business could result in you losing your investment. On the other hand, return refers to the potential profit you could make from your investment. If things go well, you earn a return on your investment.

Risk and return form the basis of investing as they are the parameters that investors use to evaluate the potential success and safety of their investments.

In this article, we will understand risk and return’s meaning, compare risk vs. return, know what factors affect them, and how to strike a balance between risk and return.

What are risk and return?

In finance, risk and return are two of the most widely used terms. Risk and return symbolise the trade-offs investors face when making an investment decision.

Risk is the uncertainty surrounding an investment, stock, or company. Investments are made in a company to earn profits, but risks are the obstacles that contribute to a reduction in profit or, sometimes, even lead to losses.

Whenever capital is employed in the market by an investor, it faces various risks, such as market risk, specific risks, credit risk, and liquidity risk, all of which we will discuss in detail later in the article.

Return on investment, or ROI, signifies the potential that the capital invested will result in gains. Simply put, an investment is said to have generated returns if it generates even a single rupee more than its initial investment.

However, sometimes, returns signify money lost and can be expressed negatively, as it is a common practice to denote returns as percentages of the original investments.

What is the concept of risk and return?

The risk-taking capacity of an individual is a measure of the amount of capital they can afford to lose on their initial investment. If an investment is referred to as high-risk, it means there is a probability, no matter how small, that the money invested could be lost.

On the other hand, return is the quantity of money you estimate could be gained after making a certain investment. If your investment earns even a single per cent more than your initial capital, it is regarded as a return.

Relationship between risk and return

Risk and return are highly correlated, especially when an investment you made works in the intended manner. When you make a high-risk investment, it naturally translates to higher rewards. The return you get is a reward for the high risk you were willing to take.

On the contrary, if an investment is considered low-risk or extremely safe, it generally leads to lower returns. This is because the market does not reward low-risk investments with substantial profits. After all, there is a minimal chance of losing your investment.

Risk and return of a portfolio

Investors use diversification, a strategy that allows them to choose different financial instruments with varying levels of risk and return to maximise returns and minimise risks.

Some of the most popular and widely invested financial instruments include stocks, mutual funds, bonds, and commodities. Stocks are dynamic and can see extreme fluctuations, so they are highly risky in a portfolio. When they crash, they can lead to huge losses, but when they appreciate, they also generate high returns.

On the other hand, government bonds are considered safe bets since they are low risk and promise a certain amount of return on their maturity, leading to almost zero risk and low profits.

So, a savvy investor will allocate a certain amount in their portfolio to high-risk instruments like stocks to avoid missing out on the opportunity to make higher profits. They will also allocate a substantial portion of their portfolio to low-risk vehicles like government bonds to compensate for the high risk of stocks.

In recent times, it has also become common practice to invest in different industries, sectors, and markets to spread risk. Since different markets and industries have different cycles, the idea of diversification here is to invest in a diverse range of assets to balance the overall risk and return, because the performance of one investment can offset the underperformance of another.

For example, during the COVID-19 pandemic, pharmaceuticals, e-commerce, and internet companies saw significant upward swings, while automobile and hospitality stocks did not do well.

Types of risks

Now, let us understand the different risks an investor should know to make well-informed investment decisions.

1. Market risk

Market risk arises when the prices of financial instruments move downward. It includes risks from changes in interest rates, stock prices, and currency exchange rates. Also known as systematic risk, it reflects a country's economic and political problems.

2. Specific risks

Specific risks deal with a particular company or organisation with operational or financial irregularities. To combat this risk, investors should always monitor the performance of companies and diversify their investments.

3. Credit risk

Credit risk arises when a borrower or company cannot repay a loan or fulfil their financial obligations. This leads to a financial loss for the lender. If the company is in a healthy financial state, it will be able to meet its debt repayments and other obligations on time. However, if the company is unable to do so, it can lead to defaults and poor ratings for the business.

4. Liquidity risk

Liquidity risk arises when companies cannot generate positive cash flows to meet debt obligations or maintain a healthy working capital amount.

5. Interest rate risk

Interest rate risk for a company refers to the potential impact on its financial performance due to changes in interest rates. If interest rates are suddenly hiked by central banks, the cost of borrowing for the company increases. This can lead to higher interest expenses on existing variable-rate loans and make new borrowing more expensive.

6. Inflation

Inflation risk is the erosion of the value of money, which reduces the value of long-term investments. Inflation risk becomes a cause of concern for money market instruments since the returns are so low that they can cancel out any potential gains over time.

Types of returns

Let us understand the different types of returns that you can generate through your investment.

1. Capital gains

All good investments will appreciate in value over time. When you sell these assets in the future, they will be valued much higher than their initial investment. The difference in amount is your capital gain and the return you made on this investment.

2. Dividends

Dividends are a steady source of income for investors who invest in shares of different companies and keep earning regular dividends from the company's profits. It provides a reliable source of income for investors.

3. Interest

Interest is the income earned on the money you lend to a borrower. Many companies, organisations, and governments borrow money from the markets or banks to meet expenses or make capital investments. The lender earns interest on the principal they provide as a return.

4. Rental income

Rental income is the money earned by property owners from leasing out their real estate assets, such as residential or commercial properties. This provides a consistent income stream as tenants pay rent regularly.

5. Return from currency trading

These are profits generated from trading different currencies in the foreign exchange (forex) market. Investors buy and sell currencies to take advantage of fluctuations in exchange rates and use them to get good returns.

Related articles to read

What is risk return trade off?

What is market risk definition?

What is credit risk?

What is default risk?

What is systematic risk?

What is inherent risk?

Examples of risk and return

Let’s look at a practical example to understand risk and return better.

Ananya has been investing in the stock market for many years but cannot maximise her returns. To increase her earning capacity from the markets, she reaches out to a financial advisor, Raj, so he can help her optimise her strategy.

Raj advises her to ensure she has a well-balanced and diversified portfolio. He suggests the following:

Holding shares in major Indian tech companies

Investing in major US tech companies

Investing in blue-chip stocks of Indian companies since they have strong financials

Investing in Indian government bonds for safety

Investing in mutual funds to gain exposure to a broad range of assets

This diversified approach will help Ananya get better returns and mitigate any potential losses.

How does uncertainty affect risk and return?

Whenever investors consider risk and return, they cannot rule out the fact that there will always be a certain degree of uncertainty about their investments.

Investors often use numbers to express their decisions, which can give the market a sense of mathematical certainty. However, calculations of risk and return are essentially expressions of probabilities. For instance, when an investor states that an asset has a 10% risk of loss, they mean that, based on market conditions, historical patterns of the asset, and the behaviour of similar assets, there is an expectation of a 1-in-10 chance of experiencing a loss in the future.

Similarly, for returns, if there is a chance of 10% returns on a given asset, it means that after taking into account potential risks, there is a possibility the asset will give you back 10% more than your initial investment.

Every asset comes with a different risk and return profile that depends on several factors, some of which are:

Market conditions

Historical performance

Asset type

Economic factors

Industry trends

Key takeaways

A risk is the chance, probability, or odds that you, as an investor, will lose money on your investment. A return on investment is the gains generated over and above the initial investment.


A high-risk investment generates better returns for the investor, which is why the price of the risk is reflected in the returns.


High-risk investments do not always generate high returns. When they crash, they can lead to considerable losses for the investor.


​​Risk and return are interconnected concepts that often work in opposition. When an investment performs well, there should be a strong correlation between the level of risk taken and the return achieved.

Conclusion

As an informed investor, it is important to understand the correlation between risk and return to make better financial decisions. Although high risks can generate high returns, they also come with the downside of leading to huge losses. Low-risk investments, on the other hand, give moderate to low returns.

It is important to determine your financial objectives and risk tolerance and set realistic return expectations to make the best investment decisions. Striking the right balance between the two is the key to achieving long-term growth.

For investors seeking to begin their investment journey, the Bajaj Finserv Mutual Fund Platform offers a range of MFs designed to cater to various risk appetites and return expectations. The platform has more than 1,000 mutual fund schemes listed, and you can compare mutual funds and make investment decisions that align with your risk appetite and financial goals.

You can also use the lumpsum calculator and SIP calculator to compute expected returns.

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Frequently asked questions

What is the formula for risk and return?
The formula for calculating risk and return involves taking the return of the investment, subtracting the risk-free rate, and then dividing this result by the investment's standard deviation.

How do you analyse risk and return?
You can use standard deviation to measure risk by looking at how much an investment's returns vary over time. For example, if one stock goes up by 20% one year but drops by 10% the next, it has higher variability (or risk) compared to another stock that goes up by 5% one year and drops by 2% the next.

What is the rule of risk and return?
​​The rule of risk and return states that investments with a higher potential for losses also offer greater potential for substantial returns. Conversely, investments with lower risk tend to provide smaller returns.

Is there a relationship between risk and return?
There is a direct relationship between risk and return: higher risk typically corresponds to higher potential for both profit and loss. Following the risk-reward tradeoff principle, investments with low uncertainty (risk) generally offer lower returns, while those with high uncertainty can potentially offer higher returns.

What are the concepts of risk and return?
Risk and return refer to the trade-off investors consider when making investments. Risk pertains to the possibility of losing money, while return indicates the profit or loss potential from an investment. Generally, higher-risk investments offer the potential for greater returns, while lower-risk investments tend to offer more modest returns.

What is the principle of risk and return?
The risk-return tradeoff principle suggests that higher potential returns come with increased risk. According to this principle, low levels of uncertainty are typically associated with lower potential returns, while higher uncertainty or risk is linked to the possibility of higher returns.

How many types of risk and return are there?
Various types of risks include project-specific, industry-specific, competitive, international, and market risk. Returns include capital gains, rental incomes, interest, dividends etc.

What is the ratio between risk and return?
Traders and investors use the risk-reward ratio to manage their capital and potential losses. This ratio evaluates the expected return and risk of a trade, where higher risk typically demands a higher expected return. A recommended risk-reward ratio is usually greater than 1:3.

How do you calculate return on risk?
To calculate the return on risk using the Treynor method, use this formula:

Treynor Ratio = (Average portfolio return - Average risk-free rate) / Portfolio beta

This ratio measures how effectively an investment portfolio or fund rewards the level of risk it undertakes, similar to how R-squared assesses this relationship.

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Bajaj Finance Limited (“BFL”) is an NBFC offering loans, deposits and third-party wealth management products.

The information contained in this article is for general informational purposes only and does not constitute any financial advice. The content herein has been prepared by BFL on the basis of publicly available information, internal sources and other third-party sources believed to be reliable. However, BFL cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. 

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