Risk and Return - Econlib (2024)

Definitions and Basics

Risk-Return Trade Off, from EconomicTimes.indiatimes.com.

Definition: Higher risk is associated with greater probability of higher return and lower risk with a greater probability of smaller return. This trade off which an investor faces between risk and return while considering investment decisions is called the risk return trade off….
Description: For example, Rohan faces a risk return trade off while making his decision to invest. If he deposits all his money in a saving bank account, he will earn a low return i.e. the interest rate paid by the bank, but all his money will be insured up to an amount of….
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However, if he invests in equities, he faces the risk of losing a major part of his capital along with a chance to get a much higher return than compared to a saving deposit in a bank.

In the News and Examples

Riskless Society, from the Concise Encyclopedia of Economics

Since the late fifties the regulation of risks to health and safety has taken on ever-greater importance in public policy debates—and actions. In its efforts to protect citizens against hard-to-detect hazards such as industrial chemicals and against obvious hazards in the workplace and elsewhere, Congress has created or increased the authority of the Food and Drug Administration, the Environmental Protection Agency, the Occupational Health and Safety Administration, and Consumer Protection Agency, and other administrative agencies….
Why are some people frightened of risks and others not? Surveys of risk perception show that knowledge of the known hazards of a technology does not determine whether or to what degree an individual thinks a given technology is safe or dangerous….
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Risk
One recent study sought to test this theory by comparing how people rate the risks of technology compared to risks from social deviance (departures, such as criminal behavior, from widely approved norms), war, and economic decline. The results are that egalitarians fear technology immensely but think that social deviance is much less dangerous. Hierarchists, by contrast, think technology is basically good if their experts say so, but that social deviance leads to disaster. And individualists think that risk takers do a lot of good for society and that if deviants don’t bother them, they won’t bother deviants; but they fear war greatly because it stops trade and leads to conscription. Thus, there is no such thing as a risk-averse or risk-taking personality….

A Little History: Primary Sources and References

Harry Markowitz, biography from the Concise Encyclopedia of Economics

In 1990, U.S. economists Harry Markowitz, William F. Sharpe, and Merton H. Miller shared the Nobel Prize for their contributions to financial economics. Their contributions, in fact, were what started financial economics as a separate field of study. In the early fifties Markowitz developed portfolio theory, which looks at how investment returns can be optimized. Economists had long understood the common sense of diversifying a portfolio; the expression “don’t put all your eggs in one basket” has been around for a long time. But Markowitz showed how to measure the risk of various securities and how to combine them in a portfolio to get the maximum return for a given risk….

William Sharpe, biography from the Concise Encyclopedia of Economics

In the sixties Sharpe, taking off from Markowitz’s portfolio theory, developed the Capital Asset Pricing Model (CAPM). One implication of this model was that a single mix of risky assets fits in every investor’s portfolio. Those who want a high return hold a portfolio heavily weighted with the risky asset; those who want a low return hold a portfolio heavily weighted with a riskless asset, such as an insured bank deposit….

Advanced Resources

Risk, Uncertainty, and Profit, by Frank Knight on Econlib

FAQs

What is true about the risk and return of an investment responses? ›

The greater the risk that an investment may lose money, the greater its potential for providing a substantial return. By the same token, the smaller the risk an investment poses, the smaller the potential return it will provide.

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How do you calculate risk and return? ›

How is risk-reward ratio calculated? The risk-reward ratio is calculated by dividing the potential reward or return of an investment by the amount of risk undertaken to achieve that return. A higher ratio indicates that the potential reward is greater relative to the risk involved.

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How do you interpret risk and return? ›

The term return refers to income from a security after a defined period either in the form of interest, dividend, or market appreciation in security value. On the other hand, risk refers to uncertainty over the future to get this return. In simple words, it is a probability of getting return on security.

What is the best explanation for the relationship between risk and return? ›

A positive correlation exists between risk and return: the greater the risk, the higher the potential for profit or loss. Using the risk-reward tradeoff principle, low levels of uncertainty (risk) are associated with low returns and high levels of uncertainty with high returns.

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What is risk and return for dummies? ›

As a general rule, the higher the expected return on an investment, the higher the risk of the investment. The lower the expected return, the lower the risk.

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What is the risk vs return rule? ›

What Is Risk-Return Tradeoff? Risk-return tradeoff states that the potential return rises with an increase in risk. Using this principle, individuals associate low levels of uncertainty with low potential returns, and high levels of uncertainty or risk with high potential returns.

What is a good return to risk ratio? ›

How the Risk/Reward Ratio Works. In many cases, market strategists find the ideal risk/reward ratio for their investments to be approximately 1:3, or three units of expected return for every one unit of additional risk.

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What is risk and formula? ›

One of the most common frameworks for understanding risk is the formula Risk = Likelihood x Impact. In this article, we will explore how this formula applies to MSPs and how they can use it to manage their risks effectively.

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What is the value at risk and return? ›

Value at risk (VaR) is a measure of the potential loss that an asset, portfolio, or firm might experience over a given period of time. Standard deviation, on the other hand, measures how much returns vary over time.

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What is the conclusion of risk and return? ›

Answer: The relationship between risk and return is directly proportional. Higher risks give higher returns and vice versa.

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What is a real life example of risk? ›

If the man chooses to move his investments to those in which he could possibly lose his money, he is a taking a risk. A gambler decides to take all of his winnings from the night and attempt a bet of "double or nothing." The gambler's choice is a risk in that he could lose all that he won in one bet.

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What is the purpose of risk and return? ›

The concept of risk and return makes reference to the possible economic loss or gain from investing in securities. A gain made by an investor is referred to as a return on their investment. Conversely, the risk signifies the chance or odds that the investor is going to lose money.

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What is the general rule regarding risk and return? ›

Rule one: Risk and return go hand-in-hand. Higher returns mean greater risk, while lower returns promise greater safety.

Does higher risk mean higher return? ›

High-risk investments may offer the chance of higher returns than other investments might produce, but they put your money at higher risk. This means that if things go well, high-risk investments can produce high returns. But if things go badly, you could lose all of the money you invested.

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What is the formula for risk and return? ›

It is calculated by taking the return of the investment, subtracting the risk-free rate, and dividing this result by the investment's standard deviation.