Risk and return are, effectively, two sides of the same coin. In an efficient market, higher risks correlate with more robust potential returns. At the same time, lower returns connect with safer (lower risk) investments. Together, these concepts define how investors choose their assets in the marketplace and how investors set asset prices. Let’s break down how this relationship affects your investments.
Risk considers that your investment could suffer a loss, while the return is the amount you can make above your initial investment. In an efficient marketplace, a higher-risk investment must offer greater returns to offset the chances of loss.
One of the most critical aspects of the relationship between risk and return is how it sets investment prices. In an efficient market, which is a market that assigns prices based on the value of the underlying assets, an asset’s price reflects the balance between its risk of loss and its potential return.
When investors evaluate risk and return, they must consider a level of investment uncertainty. The numbers that investors use to express their decisions convey a sense of mathematical certainty to the market, but ultimately risk and return calculations express probabilities. For example, suppose an investor says that an asset has a 10% risk of loss. In that case, they mean that based on market conditions, the asset’s historical patterns, and the behaviour of similarly situated assets, they expect a 1-in-10 chance of loss going forward.
Ergo, risk and investment return are perhaps the most crucial parameters investors consider when choosing an investment option. Individuals who invest on a large scale analyse the risks involved in a particular investment and the returns it can yield.