Financial Markets, Instruments and Investment Basics , The Risk-Return Trade-Off

Financial Markets, Instruments and Investment Basics

Chapter: 1 Financial Markets, Instruments and Investment Basics

Section: 8 The Risk-Return Trade-Off

Investors invest for anticipated future returns that can not be predicted precisely. There will almost always be risk associated with investments and actual or realized return will almost always deviate from the expected return anticipated at the start of the investment period. If two securities with similar returns have varying degree of risk, all investors will obviously go for the low risk security and the high demand would increase the price of security, thus decreasing the expected return. Hence, based on market demand dynamics, the security with low risk will offer a lower return while the security with higher risk will offer higher return. This is the fundamental truth in financial markets: securities with high risk will have to offer a high expected return to be attractive for investment while securities with low risk will still have demand even if they offer a lower return. Hence we see that government bonds have a very low expected return while the expected return of stocks (which are supposed to be more risky) is much higher in comparison. Therefore, the return is directly proportional to the risk and in order to earn higher return, investors will have to accept higher risk.

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