Risk Return

risk returnThe risk return tradeoff could easily be called the ability-to-sleep-at-night test.

Risk return involves the chance an investment’s actual return may differ from the expected return. Risk includes the possibility of losing some or all of the original investment. Different versions of risk return are usually measured by calculating the standard deviation of the historical returns or average returns of a specific investment.

A high standard deviation indicates a high degree of risk. Many companies allocate large amounts of money and time in developing risk management strategies to help manage risks associated with their business and investment dealings. A key component of the risk management process is risk assessment, which involves the determination of the risks surrounding a business or investment.

A fundamental idea in finance is the relationship between risk and return. The greater the amount of risk an investor is willing to take, the greater the potential return. Investors need to be compensated for taking on additional risk. For example, a U.S. Treasury bond is considered one of the safest, or risk-free, investments and when compared to a corporate bond, provides a lower rate of return. A corporation is much more likely to go bankrupt than the U.S. government. Because the risk of investing in a corporate bond is higher, investors are offered a higher rate of return.

In the financial world, risk management is the process of identification, analysis and acceptance or mitigation of uncertainty in investment decisions. Essentially, risk management occurs when an investor or fund manager analyzes and attempts to quantify the potential for losses in an investment and then takes the appropriate action (or inaction) given his investment objectives and risk tolerance.

Risk management occurs everywhere in the financial world. It occurs when an investor buys low-risk government bonds over riskier corporate bonds, when a fund manager hedges his currency exposure with currency derivatives, and when a bank performs a credit check on an individual before issuing a personal line of credit.  Stockbrokers use financial instruments like options and futures, and money managers use strategies like portfolio and investment diversification to mitigate or effectively manage risk.

Many investors use a risk reward ratio to compare the expected returns of an investment to the amount of risk undertaken to capture these returns. This ratio is calculated mathematically by dividing the amount the trader stands to lose if the price moves in the unexpected direction (the risk) by the amount of profit the trader expects to have made when the position is closed (the reward). Often, what investors really want to know is not just how much an asset deviates from its expected outcome, but how bad things look way down on the left-hand tail of the distribution curve.

The risk return ratio is most often used as a measure for trading individual stocks. The optimal risk/reward ratio differs widely among trading strategies. Some trial and error is usually required to determine which ratio is best for a given trading strategy, and many investors have a specified risk/reward ratio for their investments. In many cases, market strategists find the ideal risk reward ratio for their investments to be 1:3. Investors can manage risk/reward more directly through the use of stop-loss orders and derivatives.

Investors often use stop-loss orders when trading individual stocks to help minimize losses and directly manage their investments with a risk return focus. A stop-loss order is a trading trigger placed on a stock that automates the selling of the stock from a portfolio if the stock reaches a specified low. Investors can automatically set stop-loss orders through brokerage accounts and typically do not require exorbitant additional trading costs.

Investors use a variety of tactics to ascertain risk.  One of the most commonly used absolute risk metrics is standard deviation, a statistical measure of dispersion around a central tendency. You look at the average return of an investment and then find its average standard deviation over the same time period. Normal distributions (the familiar bell-shaped curve) dictate that the expected return of the investment is likely to be one standard deviation from the average 67% of the time and two standard deviations from the average deviation 95% of the time. This helps investors evaluate risk numerically. If they believe that they can tolerate the risk, financially and emotionally, they invest.

Investing with a risk reward focus for individual stocks using stop-loss orders can significantly help investors to manage the overall risk on their investments. Stop-loss orders allow investors to place a sell trigger on their investments at essentially only the trading cost of the block trade. With this trading mechanism in place, investors can manipulate risk reward ratios to their benefit by setting a specified risk reward ratio of their choosing per investment.

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