Risk and Return in Financial Management: A Detailed Guide

Investing is a give-and-take somewhere in between a risk and a reward. The bigger the gain, the bigger the loss. This article will discuss the key relationship between risk and return in finance. You’ll learn with clear definitions, utility, practical examples, and an overview of different types of assets as to why risk is a necessary part of any returns. Whether you are an experienced investor or managing your finances, understanding how risk interacts with return is vital to informed decision-making.

Defining Risk and Return

Risks in Financial Management

• Probability of Loss: The term used is how much of your investment will likely deteriorate within that time.
• Return Volatility determines how much an investment’s yield or revenue-generative capability can fluctuate. The standard deviation is applied to measure the fluctuation of the returns from the average.

So if you purchase a high-risk stock, for example, if the company goes bankrupt, you are done for. However, there is a tendency for its stock’s returns to be volatile, which is a good thing, bearing in mind that the returns may be very high at times.

Also Read: Financial Management – Meaning, Scope and Importance

Returns in Financial Management

The profit you make when you invest is called return. Normally expressed as a percentage of an initial investment over a given period. There are two main types of returns:

• Nominal Return: This includes the impact of inflation.
• Real Return: This leaves out the effects of inflation and gives you a better sense of what the investment is worth.

For instance, let’s say you invest $100, and then one year, it has grown to $120. The nominal return is calculated as:

This gives us the Nominal Return of (120 / 100)-1 = 0.2 or 20%.

If the inflation rate during that year were 3%, the real return would be:

Real Return = 20% – 3% = 17%

Calculating Returns

Calculating returns is important to evaluate your investment. Here’s a simple formula for nominal return:

In other words, the value is found by multiplying the Investment’s Ending value by the Initial Investment and then doing a mathematical subtraction of one on that product.

• Initial investment: $100
• Ending value: $120

The nominal return is: (120 / 100) – 1 = 0.2 or 20%

To calculate the real return, subtract the inflation rate from the nominal return:

20% – 3% = 17%

Instead of nominal returns, which account for inflation, real returns help you better understand exactly how much you make after considering inflation.

Also Read: Scope of a Career in Financial Management in 2024

Based on the chance of occurrence

• Speculative Risks: Gains and losses resulting from risks. According to examples, it can mean investing in the stock market or beginning a new business.
• Pure Risks: Only the risks will result in a loss or no change. Examples include disasters (natural or otherwise.)

Based on the chance of measurability

• Financial Risks: Quantifiable risk, such as a money risk. Examples are Credit risk, Market risk and liquidity risk.
• Non-financial Risks: Uncountable risks measured in money. Examples are reputational risk or operational risk.

Based on behaviour

• Subjective Risks: These are risks that different people will see due to their individual experiences and ideas of logic.
• Objective Risks: Certain risks are based on statistical data and perceived similarly by most people.

Based on flexibility

• Static Risks: Those risks that stay the same regardless of time and circumstances. They might include the potential of fire or theft.
• Dynamic Risks: Those risks that change depending on the situation. Risks related to changes in consumer preferences or economic conditions are examples.

Based on coverage

• Fundamental Risks: Risk of widespread. Natural disasters or recessions are examples.
• Particular Risks: Including risks which affect an individual or a small group. Examples include a car accident or a home burglary.

Based on diversification

• Diversified or Unsystematic Risks: Things that can be reduced or mitigated with diversification. Examples include company and industry-specific risks.
• Non-diversified or Systematic Risks: Risks that cannot be diversified away and impact the entire market. Interest rate risk and inflation risk are examples.

Also Read: the 5-Step Risk Management Process

The Risk-Return Relationship

Investing is all about a principle relating to the relationship between risk and return. There is generally a risk-return. That does not mean you should always distance yourself from high-risk investments. What it is – is the proper proportions depending on the goal of the planned financial investment and the maximum risk you can afford.

For instance, to lower risk slightly but not prevent the long-term decline in real returns, you can diversify your investments (spread them into various assets). Different assets are reacting in different ways to market conditions.

Different Asset Classes

So, investments can be of various types, and the opportunities and risks of such investments also vary. Here’s a look at some common asset classes:

• Risk-Free Bonds: These are very safe because the government can print money to pay off debts issued by governments. Low risk and also offer low returns.
• Money Market Securities: Short of somewhat higher risk than risk-free bonds, but with short-term returns.
• Bonds: Corporations and governments each issue these. The return on money market securities is higher, and they are riskier.
• Public Equities (Stocks): Any publicly traded company. These are high returns but at great risk (due to market volatility).
• Private Equity: Private investments in privately held companies, not on public exchanges. However, these can provide very high returns since they are so much riskier, such as liquidity risk.

Also Read: Top 9 Functions of Financial Management

Conclusion

You need to understand the risk and return of the investment. You can balance these two factors simultaneously and have a portfolio with your financial goals and risk tolerance. Whether investing in risk-free government securities or highly risky private equity, you must know how to use risk and return to manage the financial markets.

It means that being an intelligent investor is to understand that high risk generates high revenues. However, with techniques such as diversification, you can still reach your purposes with this risk being managed. Your interest in Finances is genuine, and to gain further guidance, refer to the Certificate Program in Financial Analysis, Valuation, & Risk Management With EdX by Hero Vired.