Analysis of the Relationship between Risk and Rate of Return

Analysis of the Relationship between Risk and Rate of Return 

Corporations operate in a dynamic business environment, which requires them to come up with practical business models that could help them to remain competitive. Businesses are keen on maximizing their returns, gains, and earnings by investing surplus funds but at the same time minimize risk since it is costly. Businesses have to risk investments if they are to get significant returns considering that the two aspects correlate. Soni and Somaiya (2017) note that there is a positive correlation between risk and investment in that a higher risk investment could result in a greater return. On the other hand, a lower risk investment could result in lowered profits. It is important to note that a higher risk investment could also result in a higher loss of capital or greater losses depending on the prevailing market conditions. The pyramid of investment risk is a tool that could be used to analyze the relationship between risk and rate of return associated with different investment options. The risks, which are associated with loss of capital increase as corporations, go up the pyramid and so do the potential for getting higher returns on the initial investment.

Formulation of a Portfolio that Would Minimize the Risk and Maximize Rate of Return 

Investors are keen on minimizing the risk while maximizing returns thus the need to formulate an effective and practical model. Investors could develop an efficient portfolio, which is based on Modern Portfolio Theory (MPT) a theoretical framework that businesses could adopt in analyzing risks and returns by focusing on their relationship. The framework led to the concept of efficient portfolios, which is aimed at yielding the highest return for a particular level of risk. Capital Asset Pricing Model (CAPM) is an efficient portfolio that establishes the relationship between expected returns and systematic risks. CAPM helps in pricing risky securities to come up with expected risks and returns from investments. This model captures various investment elements, which include expected return on investment, the beta of the investment risk-free rate as well as market risk premium (Birch and Muniesa, 2020). The portfolio establishes that investors require compensation for the risk they take and for the time-value of the money, they invest. The portfolio helps the investors to understand how much risk their investment will add to their portfolio. The adoption of the CAPM formula would help a corporation or an investor to establish if comparing a stock’s expected returns to the time value and risk leads to a fair evaluation.

An argument for Investment Diversification in an Investor Portfolio 

Investors who are keen on minimizing risks while minimizing return on investment have the option of diversifying their portfolio. Diversification allows investors to minimize risk by picking investments that are capable of varying in value at different values or in different ways. In this way, an investor is said to be taking advantage of the different risks that are presented in the dynamic and ever-changing investment options. In such a case if one of the investments in the portfolio loses value, the investor’s portfolio will only lose a small percentage of the total value (Theron and Vuuren, 2018). This would not be the case for a single investment which if it lost its value the loss would be significant, as an investor would not have an alternative investment. Most of the time traders diversify by trading in bonds and equities but they can expand the portfolio by trading in options and futures especially during market volatility. An investor with a diversified portfolio is in a position to preserve capital and generating returns in the long term. Portfolio diversification cushions against financial shocks considering that investments are unpredictable and may not always perform as expected (Wolski, 2017). Investors with diversified portfolios are assured of getting returns even when one or several investments perform poorly for a certain period. Other investments could be performing significantly well something that would sell the returns gaps created by the poorly performing investments owing to share market volatility. To this end, diversification is a tool that investors should adopt as a way of cushioning against risk in times of unpredictability.

Analysis of how Stocks, Bonds, Real Estate, Metals, and Global Funds may be used in a Diversified Portfolio 

Investors have the option of trading either in various asset classes, which could be cyclical, countercyclical, or invest in different sectors or firms. The diversification in both growth and defensive assets helps to reduce economic, industry, asset class, and company risks. Investors have the option of investing in stocks, bonds, real estate, metal, and global funds but must possess knowledge about their risk and return rates. Investors can diversify their portfolio by investing in stocks whereby they split the holdings between US large-cap, small-cap, emerging market, or in the international market. Wolski (2017) asserts that the various categories of stocks generate different returns during market crises and recovery periods. Investors could also diversify through bonds considering that they are significant investments in that they provide a return on capital as well as income. In such a case, a corporation could invest in a variety of US corporate, government, or foreign bonds and stick to short durations to reduce the impacts of inflation.

Real estate investment trusts (REITs) provide investors with diversification since they correlate with stocks, which translate to a more guaranteed flow of income. This investment option allows investors to pool funds, which they then invest in trusts to earn income or profit from real estate. The best thing about REITs is the fact that allows investors access to lower-cost capital, capital appreciation, and a higher yield on the initial investment (Soni and Somaiya, 2017). Apart from the REITs, investors could diversify by investing in precious metals whose value inversely correlates with currency valuations. It is important to understand that returns from investing in precious metals are prone to a shift in sentiments meaning that it may not create wealth unless there is good timing. In such a case, an investor could opt for an exchange-traded fund, which is considered a relatively low-cost and liquid option thus cushioning investors from market volatility. Moreover, investors could diversify their portfolio by investing in global funds by choosing from among either multiple or single assets. Delpini et al. (2019) note that investing in global funds located in the overseas market is likely to give higher returns as compared to other categories of investments. However, an investor needs to consider investing in global funds in emerging markets since they present higher returns as compared to developed or frontier markets.

Evaluating the Concept of the Efficient Frontier and how it could be used to determine an Asset Portfolio 

The efficient frontier is a concept in portfolio management that is derived from the modern portfolio theory that focuses on optimizing portfolios for maximum returns. Essentially, an efficient portfolio is a representation of the best combination of securities that provide maximum return for a certain risk level. Akter and Nul-Al-Ahad (2018) establish that prices of some investment options move in similar or different directions under similar conditions. If the portfolios are uncoordinated in that they have a lower covariance, it means that they present a lower risk to the investor. An efficient frontier is a crucial tool for investors considering that they tend to choose the portfolios that would generate the highest possible returns with minimal risks. It is important to understand that there is not a point on the frontiers that is better than the others are since each investor has his or her return/risk preferences. For instance, an investor may prefer a portfolio that does not include investments in volatile industries or countries or that yields minimum dividends. If an investor needs to use the efficient frontier to determine an asset portfolio, they have to understand that return and risk are directly linked (Delpini et al., 2019). In the same way, investors must understand that they can diversify their portfolio by investing in securities with different market patterns to reduce overall risk. For example, the investor may include both bonds and stocks considering that they do not tend to move in the same direction.

Consideration of the Economic Outlook for the Next Year for Ideal Portfolio that would Maximize the Rate of Return for Short-Term and Long-Term Investments 

The business world is likely to face uncertainties if the economic outlook for 2021 is something to go by considering that it is a product of negative impacts of COVID-19. The International Monetary Fund (2020) projects that the global economy would grow at 5.4 percent in 2021, which is about 6.5 percent, lower. These statistics indicate that the world will experience a gradual recovery from the effects of the pandemic that is associated with greater scarring and lowered productivity. Moreover, the economic outlook appears to indicate that there will be greater market volatility, which could translate to greater losses of capital. This forecast means that investors have to come up with ideal portfolios that would maximize the rate of return in both the short and long-term. There is a need for investors to diversify their portfolios in the coming year to deal with the anticipated market volatility. In such a case, investors could invest in short-term options that include conservative stocks, short-term bonds, liquid funds, and mutual funds, and index futures. These short-term investments are quite feasible since they cushion against inflation or losses in as much as they have lower returns as compared to long-term investments (Weintraub and Merrill, 2017). On the other hand, investors could opt for long-term investment options such as high-quality corporates, money market funds, long-term bonds, stocks, and real estate. These long-term options are considered a low risk at such a time since they can cushion investors from inflation although they may be associated with low returns. The bottom line is for investors to consider their risk appetite, liquidity needs, returns, and time horizon before settling for either long or short-term investments. 

Differences between Long-Term and Short-Term Investments 

Short term and long-term investments present differences in terms of time horizons, rate of return as well as levels of anticipated risks. Long-term investments last more than one year while short-term investments last for less than a year. Moreover, long-term investments are associated with risks emanating from fluctuations and market volatility while short-term investment risk reduced purchasing power. Weintraub and Merrill (2017) note that there is no way of knowing if the markets will go up or down for short-term investments as compared to long-term investments where investors do not have to time the market. The other main difference between the two is the investment goals that they meet. Short-term investments are appropriate for funding nearer projects while long-term investments are directed towards retirement or inheritance.

References 

Akter, S., & Nul-Al-Ahad, M. D. (2018). Portfolio diversification and efficient frontier on equity markets and commodities. EPRA International Journal of Economic and Business Review , 6 (2), 59-63.

Birch, K., & Muniesa, F. (2020). Assetization: Turning things into assets in technoscientific capitalism. Massachusetts Institute of Technology.

Delpini D., Battiston, S., Caldarelli, G., & Riccaboni, M. (2019) Systemic risk from investment similarities . PLoS ONE , 14 (5): e0217141. https://doi.org/10.1371/journal.pone.0217141

International Monetary Fund. (2020, June). World economic outlook update: a crisis like no other, an uncertain recovery. WEOENG202006.pdf

Soni, R., & Somaiya, K. J. (2017). Designing a portfolio based on risk and return of various asset classes. International Journal of Economics and Finance , 9 (2), 142-149. doi:10.5539/ijef.v9n2p142

Theron, L., & Vuuren, G. (2018). The maximum diversification investment strategy: A portfolio performance comparison. Cogent Economics & Finance , 6 (1), 1-16. DOI: 10.1080/23322039.2018.1427533

Weintraub, M., & Merrill, M. (2017). Investment risks: Short-term vs. long-term. American College of Cardiology. https://www.acc.org/latest-in-cardiology/articles/2017/05/15/15/fiscal-matters-investment-risks-short-term-vs-long-term

Wolski R. (2017). Risk and return in the real estate, bond, and stock markets. Real Estate 

Management and Valuation , 25(3), 15-22.DOI: 10.1515/remav-2017-0018