The risk and return principle holds that the rate of return increases with an increase in the risk involved in an investment. The concept explains that the higher the risk, the vast the potential profits. Thus, based on the risk to return principle, individuals and investors associate the level of returns to the degrees of uncertainty in the investment. The trade-off between risk and return as posited by the risk and return principle asserts that investments can render a high profit or return when the investor is ready to take the risk of a higher possibility of loss (Bali and Zhou, 2016). This concept explains an existing link between high rewards when a more significant risk is taken. Taking an appropriate risk-return trade-off is a complex process to investors, for it depends on many factors, including the investor's risk tolerance levels, the investment length of time, and ability to replace the lost funds in the event of a loss.
According to Petersen and Kumar (2015), the principle of risk and return is essential for decision making as investors have to trade off the risk-return to establish an appropriate investment portfolio. Some of the aspects of risk-return trade-off at the portfolio level include assessment of the level of concentration to develop possible diversification to ensure the risk involved is tolerable. Through the risk-return trade-off, investors can create an appropriate portfolio mix that presents a minimal risk or relatively lower than desired returns (Korteweg, 2019) . For example, an investor may use the principle of risk and return to decide on whether to invest in equities over the long term for a relatively lower than desired return. The longtime of investment has the potential to recover in bear markets compared to investing in the short time frames where the profits to the equities may be relatively high but at a very greater-risk proposition.
Delegate your assignment to our experts and they will do the rest.
The concept of risk and return can be used in the context of the whole portfolio consideration or singular investment basis. Thus, in the case of investment analysis considerations of high profits for high-risk investments, investors can consider the investment either as a complete portfolio or on a sole investment basis. For example, in the event of analyzing high return high-risk investments like leveraged ETFs – Exchange Traded Funds, penny stocks, and options, a trade-off between risk and return can be done either as a portfolio at large or in terms of singular investment basis (Bali and Zhou, 2016). However, the general and best means of reducing risk in either individual singular investments or the total portfolio is diversification of investments. For example, on a singular basis, a penny stock position may have a high risk with a potentially massive return. Still, the same penny stock position may have minimal risk and a relatively low return if the investment is in a vast portfolio.
The principle of risk and return presents a risk-return spectrum where various types or classes of investments provide a different risk-return position. Investments can be classified as equities, high-yield debts, property, long term investments, and short-term investments in a retrogressive hierarchy. The risk aspect of investment causes the need to consider the possibility of expenses in an investment (Petersen and Kumar, 2015) . A good example is when one needs to undertake a risky venture; there is a need for more time and effort to seek more information about the investment and how to monitor it. Risk in investment is something that should always be compensated for in the process, and the more the risk involved; then, the higher should be the compensation required for the investment. However, it does not always mean that riskier the investments, the higher the returns because of risk-return variability.
In the risk-return trade-off at the portfolio level, it is imperative to ensure a sound investment that is to guarantee potential return and tolerable risks. Explicitly, a risk-return trade-off occurs at the whole portfolio level (Korteweg, 2019) . A good example is when a portfolio is composed of equities; it presents both high potential returns and high risk. When a portfolio is composed of all equities, the return and risk are increased by taking an investment position that takes a single spot with a very high percentage holding or when the investment is concentrated in one specific sector (Korteweg, 2019) . Thus, for investors, analysis of the cumulative return to the risk involved in the investment provides the investors' insight on whether the investment assumes the desirable risk or the risk is too high beyond the investor risk tolerance levels.
In conclusion, trading off risk and return is an essential consideration in making capital decision budgeting. The concept of risk and returns provides an insight into the variability of possible returns to investment. For firms to make investment decisions, they must compare the risk associated with the investment and the expected returns. In business, it is natural to seek a relatively high gain in the risk as compensation for the increased risk involves in an investment. In other words, firms that consider making profitable investments count on riskier stakes to get generous returns. In contrast, risk-averse firms take a lower risk for a little to moderate returns. When making capital budgeting decisions, firms aspire to, on the bare minimum, recover their cost of investment as well as cover for any expenses incurred due to inflation.
References
Bali, T. G., & Zhou, H. (2016). Risk, uncertainty, and expected returns. Journal of Financial and Quantitative Analysis , 51 (3), 707-735.
Korteweg, A. (2019). Risk Adjustment in Private Equity Returns. Annual Review of Financial Economics , 11 , 131-152.
Petersen, J. A., & Kumar, V. (2015). Perceived risk, product returns, and optimal resource allocation: Evidence from a field experiment. Journal of Marketing Research , 52 (2), 268-285.
