Page 74 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 4: Risk and Return Analysis

terrified to climb the financial ladder without a secure harness. Deciding what amount of risk Notes
you can take while remaining comfortable with your investments is very important.

In the investing world, the dictionary definition of risk is the possibility that an investment's
actual return will be different than expected. Technically, this is measured in statistics by standard
deviation. Risk means you have the possibility of losing some, or even all, of your original
investment.
Low levels of uncertainty (low risk) are associated with low potential returns. High levels of
uncertainty (high risk) are associated with high potential returns. The risk/return trade-off is the
balance between the desire for the lowest possible risk and the highest possible return. This is
demonstrated graphically in the chart below. A higher standard deviation means a higher risk and
higher possible return. The figure below represents the relationship between risk and return.

Figure 4.1: Risk and Return Relationship

Return

Low risk Average risk High risk M

Slope indicates required

required
Return per unit of risk
Risk-free return R(f)

The slope of the Market Line indicates the return per unit of risk required by all investors.
Highly risk-averse investors would have a steeper line, and vice versa. Yields on apparently
similar stocks may differ. Differences in price, and therefore yield, reflect the market's assessment
of the issuing company's standing and of the risk elements in the particular stocks. A high yield
in relation to the market in general shows an above average risk element. This is shown in the
Figure 4.2.

Given the composite market line prevailing at a point of time, investors would select investments
that are consistent with their risk preferences. Some will consider low-risk investments, while
others prefer high-risk investments.
A common misconception is that higher risk equals greater return. The risk/return trade-off
tells us that the higher risk gives us the possibility of higher returns. But there are no guarantees.
Just as risk means higher potential returns, it also means higher potential losses.
On the lower end of the scale, the risk-free rate of return is represented by the return on Treasury
Bills of government securities, because their chance of default is next to nil. If the risk-free rate
is currently 8 to 10%, this means, with virtually no risk, we can earn 8 to 10% per year on our
money.

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