There are two primary concerns for all investors: the rate of return they can expect on their investments and the risk involved with that investment. While investors would love to have an investment that is both low risk and high return, the general rule is that there is a more or less direct trade-off between financial risk and financial return. This does not suggest that there is some perfect linear relationship between risk and return, but merely that the investments that promise the greatest returns are generally the riskiest.
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A risk-free investment is an investment that has a guaranteed rate of return, with no fluctuations and no chance of default. In reality, there is no such thing as a completely risk-free investment, but it is a useful tool to understand the relationship between financial risk and financial return. According to basic concepts of market economics, there would be such a high demand for a risk-free investment that the institution owning the assets underlying the investment would set the rate of return to something essentially equal to the time value of that investment. In other words, if you invested in a risk-free investment, your return would essentially be based entirely on the value of having money now as opposed to some point in the future. That is why interest rates on savings accounts are so low. These are virtually risk-free investments.
The calculation of financial return changes when we add risk to the equation. Assume that there are two investments you can choose from for a five-year investment period. Investment A is risk-free, and Investment B has a 50 percent chance of being completely worthless in five years. Obviously, if these two investments promised the same rate of return, no rational investor would choose Investment B. Instead, there has to be some kind of incentive to choose this riskier investment. This incentive is generally a higher rate of return or potential rate of return and is known as the risk premium.
In the debt market context, investors are primarily faced with two scenarios: they will be compensated at the promised rate of return, no more and no less; or they will lose all of their investment. With stock investments, the possibilities of returns are virtually infinite. A stock could become completely worthless or worth an unimaginable amount of money. This is because the value of a stock is determined by market forces that cause the stock to increase or decrease in value over time. This is known as volatility. A stock with higher highs and lower lows is more volatile, and therefore riskier. However, because this stock has higher highs, it has a higher potential rate of return.
Portfolios and Managing Risk
A portfolio is a collection of investments. A smart investor will not put all his eggs in one basket and invest entirely in one stock. Instead, most investors choose a collection of investments with varying levels of risk and return. By manipulating the proportion of risky stocks in his portfolio, an investor can manipulate his level of risk and potential return.