RISK AND RETURN

The term "risk and return" refers to the potential financial loss or gain experienced through investments in securities. An investor who has registered a profit is said to have seen a "return" on his or her investment. The "risk" of the investment, meanwhile, denotes the possibility or likelihood that the investor could lose money. If an investor decides to invest in a security that has a relatively low risk, the potential return on that investment is typically fairly small. Conversely, an investment in a security that has a high risk factor also has the potential to garner higher returns. Return on investment can be measured by nominal rate or real rate (money earned after the impact of inflation has been figured into the value of the investment).

Different securities—including common stocks, corporate bonds, government bonds, and Treasury bills—offer varying rates of risk and return. As Richard Brealey and Stewart Myers noted in their book Principles of Corporate Finance, "Treasury bills are about as safe an investment as you can get. There is no risk of default and their short maturity means that the prices of Treasury bills are relatively stable." Long-term government bonds, on the other hand, experience price fluctuations in accordance with changes in the nation's interest rates. Bond prices fall when interest rates rise, but they rise when interest rates drop. Government bonds typically offer a slightly higher rate of return than Treasury bills.

Another type of security is corporate bonds. Those who invest in corporate bonds have the potential to enjoy a higher return on their investment than those who stay with government bonds. The greater potential benefits, however, are available because the risk is greater. "Investors know that there is a risk of default when they buy a corporate bond," commented Brealey and Myers. Those corporations that have this default option, though, "sell at lower prices and therefore higher yields than government bonds." In the meantime, investors "still want to make sure that the company plays fair. They don't want it to gamble with their money or to take any other unreasonable risks. Therefore, the bond agreement includes a number of restrictive covenants to prevent the company from purposely increasing the value of its default option."

Investors can also put their money into common stock. Common stockholders are the owners of a corporation in a sense, for they have ultimate control of the company. Their votes—either in person or by proxy—on appointments to the corporation's board of directors and other business matters often determine the company's direction. Common stock carries greater risks than other types of securities, but can also prove extremely profitable. Earnings or loss of money from common stock is determined by the rise or fall in the stock price of the company.

There are other types of company stock offerings as well. Companies sometimes issue preferred stock to investors. While owners of preferred stock do not typically have full voting rights in the company, no dividends can be paid on the common stock until after the preferred dividends are paid.

RISK AND RISK AVERSION

Many types of risk loom for investors hoping to see a return on their money, noted Jae K. Shim and Joel G. Siegel in their Handbook of Financial Analysis, Forecasting, & Modeling. Business risk refers to the financial impact of basic operations of the company. Earnings variables in this area include product demand, selling price, and cost. Liquidity risk is the possibility that an asset may not be sold for its market value on short notice, while default risk is the risk that a borrower company will be unable to pay all obligations associated with a debt. Market risk alludes to the impact that market-wide trends can have on individual stock prices, while interest rate risk concerns the fluctuation in the value of the asset as a result of changes in interest rate, capital market, and money market conditions.

Individual risk aversion is thus a significant factor in the dynamics of risk and return. Cautious investors naturally turn to low-risk options such as Treasury bills or government bonds, while bolder investors often investigate securities that have the potential to generate significant returns on their investment. Certain types of common stock that fit this description include speculative stocks and penny stocks.

Many factors can determine the degree to which an investor is risk-averse. William Riley and K. Victor Chow contended in Financial Analysts Journal that "relative risk aversion decreases as one rises above the poverty level and decreases significantly for the very wealthy. It also decreases with age—but only up to a point. After age 65 (retirement), risk aversion increases with age." Riley and Chow note that decreases in risk aversion often parallel higher degrees of education as well, but speculate that "education, income and wealth are all highly correlated, so the relationship may be a function of wealth rather than education."

Economically disadvantaged families are, on the surface, often seen as risk-averse; in actuality, however, decisions by these households to avoid investment risk can be traced to a lack of discretionary income or wealth, rather than any true aversion. As Riley and Chow noted, "risk aversion can … be expected to decrease as an individual's wealth increases, independent of income. Someone whose stock of wealth is growing can be expected to become less risk-averse, as her tolerance of downside risk increases."

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