Risk and Return in Investment: Meaning, Types & Examples

 Investment – Risk and Return

Investment is an economic activity that involves the allocation of funds to assets with the objective of earning income or capital appreciation. Every investment has two fundamental attributes:

1. Risk
2. Return

Investment requires the sacrifice of present consumption in anticipation of future benefits. This sacrifice is certain, whereas the return expected in the future is uncertain. The uncertainty of future returns gives rise to investment risk.

Risk is undertaken with the expectation of earning a return. The level of risk assumed by an investor generally influences the magnitude of the return expected. Higher risk is associated with the potential for higher returns and vice versa.

For example, when a person commits funds to purchase a flat or a house for personal use, it cannot be considered a true investment. Although it involves financial commitment and risk, it does not generate regular income or financial return.

Concept of Risk and Return

Risk and return are fundamental concepts in investment analysis and play a crucial role in understanding market behavior. There is a direct relationship between risk and return: investments carrying higher risk offer the potential for higher returns, while lower-risk investments generally provide lower returns.

Investors have several motives for investing, but the most important objective is to earn a return on their investment. However, selecting investments solely on the basis of maximum expected return is not sufficient. The fact that most investors allocate their funds across more than one security indicates that factors other than return must be considered.

This leads to the concept of portfolio selection, where risk and return are analyzed together. Investors aim to achieve an optimal balance between risk and return by diversifying their investments.

To understand investment decisions in the context of risk and return, the following aspects must be clearly examined:

1. What is risk and what is return?
2. What factors create risk and return?
3. How can risk and return be measured?

Return

Return is the motivating force and principal reward in the investment process. It represents the benefit an investor receives from committing funds to an asset. Return may be expressed as a realized return, which is the return actually earned during a past period, or as an expected return, which is the return anticipated in the future.

Return is defined as: “The income received on an investment plus any change in its market price, usually expressed as a percentage of the investment’s beginning market price.”

Components of Return

1. Yield

Yield is the most common form of return and refers to the periodic cash income generated by an investment. It may take the form of:

• Interest on bonds and debentures
• Dividends on equity and preference shares

2. Capital Gain (or Loss)

Capital gain refers to the increase in the market price of an asset over time. If the price decreases, it is known as a capital loss.

Total Return - Total return combines both income and price change and is calculated as:

Where:

• TR = Total return
• Dₜ = Cash dividend received at the end of period t
• Pₜ = Price of the asset at time t
• Pₜ₋₁ = Price of the asset at the beginning of the period

Example: Total Return Calculation

ABC purchased a stock for ₹6,000. At the end of the year, the stock’s market value increased to ₹7,500. During the year, ABC received dividends of ₹260.

Total return earned by ABC = 29.3%

Expected Return

Expected return is the return an investor anticipates earning in the future. It is a predicted value and may not actually occur. Investors estimate expected return to evaluate investment decisions under uncertainty. For an investor, return may arise in the form of:

• Dividends
• Interest
• Capital gains
• Bonus shares, etc.

Key characteristics of expected return:

1. The investor cannot be certain about the actual return
2. Multiple outcomes are possible
3. Expected return is calculated as a weighted average of possible returns, where the weights are the probabilities of occurrence

Formula for Expected Return

Where:

• X = Possible returns
• P(X) = Probability of each return

Example: Expected Return

Suppose an investment has:

• A 50% chance of earning ₹10
• A 25% chance of earning ₹20
• A 25% chance of incurring a loss of ₹10

Return (X)	Probability P(X)	X × P(X)
10	0.50	5.00
20	0.25	5.00
−10	0.25	−2.50
Total		7.50

Expected return = ₹7.50

Risk

In investment, risk refers to the uncertainty associated with future returns. It implies that the actual return from an investment may differ from the expected return. Since future outcomes are unpredictable, every investment involves some degree of risk.

According to Irving Fisher, “Risk is a combination of hazards measured by probability.”

In simple terms, risk is the variability between expected returns and actual returns.

Components of Risk

Investment risk is broadly classified into two components:

1. Systematic Risk
2. Unsystematic Risk

1. Systematic Risk

Systematic risk affects the entire market or a large segment of the market. It arises due to external factors beyond the control of an individual company and cannot be eliminated through diversification. Changes in economic conditions, political situations, and social factors significantly influence the securities market.

Systematic risk is further classified into the following categories:

1. Market Risk - Jack Clark Francis defines market risk as the portion of total return variability caused by the alternating forces of bull and bear markets. Market fluctuations account for a major share of the variability in security returns.
2. Interest Rate Risk - Interest rate risk refers to the variation in returns caused by changes in market interest rates. It primarily affects the prices of bonds, debentures, and equities. This risk generally arises due to changes in government monetary policy.
3. Purchasing Power Risk - Purchasing power risk is the potential loss in the real value of returns due to inflation. Inflation may be:
• Demand-pull inflation, or
• Cost-push inflation
• As inflation rises, the purchasing power of future income declines.

2. Unsystematic Risk

Unsystematic risk is specific to a particular company or industry. It arises from internal and operational factors such as technological changes, availability of raw materials, changes in consumer preferences, and labor issues. Unlike systematic risk, unsystematic risk can be reduced or eliminated through diversification.

Unsystematic risk is classified into the following types:

1. Business Risk - Business risk arises from the operating environment of a firm and reflects the firm’s ability to maintain stable earnings and competitive strength. It can be further divided into:
• Internal Business Risk - Internal business risk arises from factors within the firm, such as:
• Fluctuations in sales
• Research and development efficiency
• Personnel management
• High fixed operating costs
• Dependence on a single product
• External Business Risk - External business risk arises from factors beyond the control of the firm, including:
• Social and regulatory changes
• Political risk
• Business cycle fluctuations
2. Financial Risk -  Financial risk is associated with the capital structure of a company, particularly the proportion of debt and equity financing. The use of borrowed funds increases fixed financial obligations such as interest payments, thereby increasing the risk to equity shareholders.

Frequently Asked Questions (FAQs)

What is meant by risk in investment? What is return in investment?

Risk in investment refers to the uncertainty of future returns. It is the possibility that the actual return may differ from the expected return due to market, economic, or company-specific factors. Return is the reward an investor receives from an investment. It includes income such as dividends or interest and capital gains or losses arising from changes in the market price of the asset.

What is the relationship between risk and return?

Risk and return are directly related. Generally, higher risk investments offer the potential for higher returns, while lower risk investments provide relatively stable but lower returns.

What is expected return?

Expected return is the return an investor anticipates earning in the future. It is calculated as the weighted average of all possible returns, with probabilities assigned to each outcome.

What is systematic risk?

Systematic risk is market-wide risk that affects all securities and cannot be eliminated through diversification. Examples include market risk, interest rate risk, and purchasing power (inflation) risk.

What is unsystematic risk?

Unsystematic risk is company- or industry-specific risk arising from internal factors such as management inefficiency, labor problems, or changes in consumer preferences. It can be reduced through diversification.

What is business risk?

Business risk arises from a firm’s operating environment and its ability to maintain stable earnings. It includes both internal risks (like high fixed costs) and external risks (like political or regulatory changes).

What is financial risk?

Financial risk arises due to the use of borrowed funds in a company’s capital structure. Higher debt increases fixed financial obligations, thereby increasing the risk to shareholders.

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