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Unit 4: Measuring Investment Return

live in the house for a very long period of time, the act of purchasing a house or apartment may Notes
be taken as an investment activity.

4.1 Risk and Return Trade-off

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.

The most fundamental tenet of finance literature is that there is a trade-off between risk and
return. The risk-return relationship requires that the return on a security should be commensurate
with its riskiness. If the capital markets are operationally efficient, then all investment assets
should provide a rate or return that is consistent with the risks associated with them. The risk
and return are directly variable, i.e., an investment with higher risk should produce higher
return.
The risk/return trade-off could easily be called the “ability-to-sleep-at-night test.” While some
people can handle the equivalent of financial skydiving without batting an eye, others are
terrified to climb the financial ladder without a secure harness. Deciding what amount of risk
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 figure 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

Return per unit of risk

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