When you put your effort, trust and money into something, you expect them to bear returns after a certain period. Essentially, you will be risking all these aspects with the hope of reaping returns. Even in business, there is a general assumption that higher risks equal higher returns, which is basically known as risk return trade-off. However, the bone of contention here is whether higher risks always lead to higher returns.
This post aims at exploring the concept of risk-return trade-off to try and come up with a solid conclusion while delivering insightful discussions on the same. Read on to learn more.
The Element of Risk
A risk involves the uncertainty about the implications or effects of an activity or an action. Therefore, risking means that you understand that there is a likely chance that what you hope for may not occur. For instance, when you start a business, you risk losing some part of your money. Although an entrepreneur’s goal is to make massive profits from his venture, it may not always be the case because the venture might fail. Some of the common ones are:
- Exchange rate risk
- Credit risk
- Interest rate risk
- Systematic risk
- Market risk
The return is what you expect after your investment matures. In finance, the return is the profit you get from the investment you made. For instance, if you put £500,000 on a fixed deposit account in your bank, with a 10% interest rate, your profit will be £50,000. This amount is what is referred to as the return on your investment (ROI).
Does Higher Risk Mean Higher Return?
Although higher risks may equal higher return, it may not always be the case. The primary reason is that it is possible to underestimate the risk involved during your investment easily.
Furthermore, it may not be exactly possible to quantify the level of risk. Nonetheless, when you use some methods like Value at Risk (VaR) or standard deviation, you may try to measure the extent of risk to figure out your return. In order to fully grasp the idea of risk-return trade-off, it is important to compare fixed return and variable return .
Fixed Return vs variable Return Investment
A fixed return investment is an investment with a known outcome or income if it’s a business. On the other hand, a variable return investment is one with uncertain or unpredictable future returns, which essentially means that they are incalculable. Below are some comparisons of the two.
1. Fixed Income Securities vs Stock
When dealing with stocks, the outcomes are highly uncertain because it is a form of variable return investment. As a stockholder, you may not know the exact dividends you will receive when the year comes to a close. This is because your dividends mostly depend on earnings. These earnings also depend on how the business performed throughout the year, which also depends on a host of other factors. Inasmuch as you might estimate the amount you can receive, you can’t be entirely sure.
Fixed deposits or bonds are types of fixed return investments, which means that you know the exact amount you will receive when you invest. For example, when a bond coupon rate is 10%, you will receive 10% of you investment in returns.
However, between bonds and stocks, you can get higher returns from investing in stocks than bonds. This is because there is a higher risk involved when you invest in stocks, even based on historical data. On the other hand, since there is higher risk involved, the probability of running into significant losses is also higher when there is a rapid market decline. There is no form of safety for your investment when the market declines in stocks as compared to fixed deposits or stocks. Conversely, you cannot expect to reap higher returns from bonds.
2. Job vs Business
When comparing a job to a business, you can also understand the risk-return trade-off concept. Inasmuch as you can rely on a job for stable and regular income long into the future, you can reap more from investing in a business. However, you have to keep in mind that a business carries significant risk compared to a job. Therefore, you are safer having a job than investing in business.
However, you should also keep in mind that investing in a business has a greater probability of offering you greater returns if it becomes successful. At the same time, the risk of failure is also as high. According to research, over 50% of businesses fail to continue their operation within five years of running. This shows that there is a higher risk of failure than there is for success in running a business. Nevertheless, higher risk businesses have a higher chance of massive payoffs than normal jobs.
The same concept can also be applied to normal jobs vs. higher-risk jobs like leaders. Although they may have higher salaries, their jobs come with significant risk.
However, certain peculiar aspects don’t subscribe to the school of thought that higher risk mean higher returns. Some of these aspects include:
- The healthcare sector: People working in the healthcare sector don’t get paid as much as their counterparts in the business. It is peculiar because healthcare risks are quite immense, especially during this period of COVIID-19. If it were entirely true, then healthcare professionals should be paid significantly higher than those in business.
- Income Taxes paid: For instance, the tax tariff imposed on employees and entrepreneurs is the same in some European countries. However an entrepreneur has to manage much higher risks than an employee (and may even employ employees in his companies). The income tax tariff therefore does not reflect the risks of an entrepreneur. This is something that would need to change in order to improve the share of entrepreneurs in Europe.
There is risk everywhere and it is part of life. Although you might want to take a higher risk for a higher return, it is only wise to take a level of risk that is within your tolerance level. If you are in a position to bear the cost of the worst outcome of your risk, then that is your tolerance level. If that risk can affect your operations, it’s not worth it. Always ask yourself how much you will gain and how much you will loose if things go right or wrong. Contact us to improve your returns.