According to Light (2013), gaining balance between the rate of return and risk is a classic puzzle in finance. In my case, the term risk reminds me of the first time I dived into a water pool from high ground. Standing on that high dive, I was ruined by the fear of missing the pool and hitting its walls. I was also shaking on thinking what water could do to me upon making inappropriate dive. However, I had to learn to swim. I had no otherwise. I had to take that risk.
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The same thing happens to investors. They fear high risks with high returns until they engage in investments and realize the need of striking a balance between the two. They always calculate and diversify their business endeavors in order to mitigate risks. By avoiding risks, they get sure of maximum returns. Otherwise, their interest rate will be lowered or the worst happens in some project that makes them lose the invested capital (Hickman, Byrd, & McPherson, 2013). They, therefore, invest in various projects ranging from trading stocks to building apartments to mitigate against risks.
Nonetheless, risk aversion is the assumption made in the theory of finance. In the real world, depending on the investors risk-utility, there are three types of investors. Investors who are risk seekers, risk-neutral and risk-averse (Hickman, Byrd, & McPherson, 2013). A risk-averse investor will always have an attached decreasing utility to every growth of wealth, a risk-neutral have an equal utility to every increase in wealth while risk seekers have an increased utility with every percentage increase in wealth (Hickman, Byrd, & McPherson, 2013).
Furthermore, no matter the route of investing, investors can never be sure of earning risk-free interest. Investing is usually associated with risk through risky cash flows, which occurs when making financial decisions but it enables them to maximize their investment returns with exposure to certain levels of risks. For instance, when a company borrows money from a bank, it risks changes in interest rates. Hence, investors should understand risk and return which helps them determine the amount and impact of risk to their business in relation to returns (Brodeur, Buehler, Patsalos-Fox, & Pergler, 2010).
Conversely, understanding risk and return require some modeling. For instance, when estimating the returns an investor expects from his new adventure in relation to risk, asset betas become handy tools (Hickman, Byrd, & McPherson, 2013). Furthermore, the return valuation formula may be used. It was derived through relating the cash flows of the project in the future, risk involving the project, and the value of invested money with the stipulated time. For the Risk involved, which is a measure of how dispersed is expected returns are, it is determined best by variance. Similarly, the rate of return is an expression of distribution. By considering the expected returns as a normal distribution, the returns from an investment are affected by the expected risk (Hickman, Byrd, & McPherson, 2013).
Consequently, there will never be investment without risking. In fact, when the risk is high, the expected earning is high and when the risk is low, the expected earning is low. According to the principle of risk-return trade-off, the price of taking some risks reflects on accrued returns (Investopedia, 2013). As a result, the higher return rates are amazing on how they establish investors quickly but with higher expected risks (Light, 2013).
However, the risk is influenced by factors such as hazard, operation, finance, and strategy. Firstly, hazard risk factors include those risks addressed through insurance like fire, pollution, or pensions. Secondly, financial risk factors consist of uncertainties caused by changes in the financial market such as interest rates, commodity prices, and foreign exchange. Thirdly, operational risk factors comprise threats related to customer satisfaction, product development, and information technology. Lastly, strategic risk factors take account of peril that may be caused by the preference of the customer, political factors, and creativeness (DArchy, & Brogan, 2001).. By risk responding to changes in these factors, it helps to get the balance between risk and return. It also mitigates risks impacts.
Brodeur, A., Buehler, K., Patsalos-Fox, M., & Pergler, M. (2010). A Board Perspective on Enterprise Risk Management. Web.
DArchy, S. P., & Brogan, J. C. (2001). Enterprise Risk Management. Journal of Risk Management of Korea, 12(1): 1-50.
Hickman, K. A., Byrd, J. W, & McPherson, M. (20113). Essentials of Managerial Finances. San Diego: Bridgepoint Education.
Investopedia (2013). Risk-Return Trade off. Web.
Light, L. (2013). How to Find Low Risk, High Return Investment. Web.