Session III – A: Corporate Finance: Risk & Return
Description: Explains the concept of Risk, the reward for bearing the risk and different types of return of Investments
Concept Title: Risk & Reward
Definition: Establishes the relationship between risk and reward
When it comes to risk, there are probably as many definitions out there as there are risks. Brought down to the simplest level, risk is only the possibility (or chance) that your expectations will not be met. You put a thousand dollars in a hot share in the stock market. Your expectation was that the money would double in six months. Was it realistic? We don’t know. Was there any risk (read: chance) that this will not happen? Absolutely!
One of the key, as well as, oldest principles of Finance (that most people have difficulty understanding) is that risks and rewards are not only related to each other but also proportionate to each other; that is, risk and reward are symmetric. The higher the risk, the higher the reward; higher the reward, the higher the risk. It’s as simple as that. For now, accept this as a fact and we will elaborate on this further as you read on.
Among other things, Finance teaches us how to breakdown risk, manage risk and determine a fair compensation for risk. A fair compensation for bearing risk is what we call return or reward (used here interchangeably). By using return per unit of risk as a benchmark, you can compare an opportunity at hand to other investment opportunities available. It’s a simple concept with very powerful applications and is commonly known as the Risk-Return Tradeoff.
Going back to our earlier example of investing a thousand dollars in a hot stock. A 100% return (double your money) in six months, in the US economy, at the turn of the 21st century is an extremely high and attractive reward. What does this imply? The risk is just as high. Even if the money doubles in six months, it would still be a very risky proposition. But is there such a thing as too much risk? There is only one answer to this question: “It Depends”.
First, just like everything else in the world, risk is also relative. It’s relative to other opportunities & to general market conditions. If the safest investment you can find is riskier than doubling your money in six months, then on a relative risk adjusted basis doubling your money is a great opportunity.
Second, it’s also a question of your risk profile. There are conservative (risk-averse) investors who cannot afford to go beyond a level of risk; there are thrill seekers (risk-seekers) who thrive on walking on the edge of the risk frontier and then there are moderates who take the middle road. Depending on who you are and where you fit in the above classes, the risk associated with “doubling your money in six months” maybe too high or too low. All risks have a buyer and can be placed (read: sold). The buyer is the person who is willing to invest in an opportunity and is willing to assume the risk that comes with the opportunity. You just have to find the right profile buyer.
An important point to remember is that just because a high return is promised there is no guarantee that it will be realized. Double your money in six months has a fine print; sometimes people forget to read between the lines. The return is conditional on success, success being the occurrence of events that leads to the high return. If the events do not occur, you may make some money, may not make any money, may lose some money or even lose all of your money… no one can say for sure.
It just depends on how risky the initial bet was.
Important Points to remember
- Risk and Reward are symmetric. High risk should earn you high reward, low risk should earn you low reward. If you see an opportunity where this does not hold then something is wrong somewhere.
- Every Risk has a buyer
- Read the fine print
- Return is conditional