It is clear that there is a relationship between risk and return, but we are not yet clear exactly what that relationship is

Résumé du document

Incertitude about expected returns is one of the criteria which influence the largest number of strategic investment decisions. Thus the relationship between risk and return is a fundamentally financial relationship, because it affects expected rates of return on investment. This relationship between risks and returns holds true for individual investors and business managers. Returns are the financial rewards obtained as result of making an investment. There are different types of returns, depending on the investment. Investments could be bonds, loan, and shares. The definition of risk is more complex than the definition of return. A risk in investment is defined a significant possibility of having a return that is different from the expected return. There are two types of risk analyses; one is the stock market analysis for shares, and the other, about credit analysis for loans and bonds. We are going to focus on the first one which has more risks, and will also provide some details about the second one.

The target of the document is to understand the relationship between risk and return and thus be in a better position to achieve financial goals.

It is an established fact that there is a relationship between risk and return, is this a relevant concept which needs to be taken into account during a financial decision making process?

On one hand, it's necessary to know how recognize a risk and return relationship, and on the other, it is relevant to analyze if this relationship is positive or negative one for investor's decisions?

Extraits

[...] The risk and return relationship, is not a clear relationship because it's impossible to assess it completely. It's not a linear relationship. It is important to use good tools of analysis to measure the effects of risks on returns. The studied sample must have a reasonable size to avoid statistical errors. Nevertheless, no model, however sophisticated, can wipe out risk factors on expected returns. Risks are foundations of companies and foundations of a bet on the future. This is why risks have a price. [...]

[...] Despite the fact that these methods regulate risks, risks are not completely suppressed. Nevertheless the risk and return relationship may be positive for some investor decisions. The demand for risky investments is less. Thus, investors expect the returns to be superior to investment. There is an extra return expected for taking on the risk. Therefore the rate of return for risky investments is equal to the usual rate of return, plus the risk prime. These risk primes may have different natures. [...]

[...] A diversified portfolio could include different categories of investments, like stocks and bonds. Investments can come from different kinds of industries and different nations. Diversification decreases systematic risks limiting the chance that one investment with a negative factor will have an important impact on the value of the portfolio. Estimated or expected return is based on CAPM which is equal to the risk free interest plus a danger money. Security Market Line defines a linear relationship between risk and return. It's a comparison between systematic risk and the returns from the market. [...]

[...] Thus the relationship between risk and return is a fundamentally financial relationship, because it affects expected rates of return on investment. This relationship between risks and returns holds true for individual investors and business managers. Returns are the financial rewards obtained as result of making an investment. There are different types of returns, depending on the investment. Investments could be bonds, loan, and shares. The definition of risk is more complex than the definition of return. A risk in investment is defined a significant possibility of having a return that is different from the expected return. [...]

[...] Even if investors do not have the same degree of aversion to risk, they will all prefer a project with a low risk level, for the same return. Also everybody uses methods to assess the risk and return relationship, and to reduce risk for higher returns. Risk can be reduced by diversification. Diversification is based on the Markowitz portfolio theory. It is possible to reduce risk by choosing investments whose returns are not perfectly related. Nevertheless, these two methods have some limits. They are not really relevant and don't suppress all the risks. The assumptions of CAPM assumptions are not applicable to the real world. [...]