Risk-Return Relationship

08/05/2021 1 By indiafreenotes

Investments with high risk tend to have high returns and vice versa. Another way to look at it is that for a given level of return, it is human nature to prefer less risk to more risk. Therefore, the higher the risk of an investment, the higher its returns have to be to attract investors.

The existence of risk does not mean that you should not invest only that you should be aware that any investment has some degree of risk which should be considered when deciding whether the expected returns of that investment are worth it.

Therefore, when considering the suitability of any investment, you must understand both the likely returns and the risks involved. The appropriate risk-return combination will depend on your financial objectives. Some people prefer a low-risk, steady income stream while others don’t mind taking on more risk for the chance of making higher returns.

Relationship between risk and return means to study the effect of both elements on each other. We measures the effect of increase or decrease risk on return of investment. Following is the main type of  relationship of risk and return:

  1. Direct Relationship between Risk and Return

(A) High Risk – High Return

According to this type of relationship, if investor will take more risk, he will get more reward. So, he invested million, it means his risk of loss is million dollar. Suppose, he is earning 10% return. It means, his return is Lakh but he invests more million, it means his risk of loss of money is million. Now, he will get Lakh return.

(B) Low Risk – Low Return

It is also direct relationship between risk and return. If investor decreases investment. It means, he is decreasing his risk of loss, at that time, his return will also decrease.

  1. Negative Relationship between Risk and Return

(A) High Risk Low Return

Sometime, investor increases investment amount for getting high return but with increasing return, he faces low return because it is nature of that project. There is no benefit to increase investment in such project. Suppose, there are 1,00,000 lotteries in which you will earn the prize of You have bought 50% of total lotteries. But, if you buy 75% of lotteries. Prize will same but at increasing of risk, your return will decrease.

(B) Low Risk High Return

There are some projects, if you invest low amount, you can earn high return. For example, Govt. of India need money. Because, govt. needs this money in emergency and Govt. is giving high return on small investment. If you get this opportunity and invest your money, you will get high return on your small risk of loss of money.