Understanding Risk and Return

Risk
Risk, in the context of investing, is defined as the volatility of returns. For the sake of quantification, risk is taken as the standard deviation of the returns earned from an investment.

Assume that Stock A’s monthly returns are 5%,-6%,10%,1%,-8% and that Stock B’s returns are 1%,0.2%,0%,-0.2%0.2% .

Stock A is considered more risky than Stock B since its standard deviation of returns is 7.5% while that of Stock B is 0.45 %. That is despite the fact that Stock A has a higher average return than Stock B.

Return
Return is the total monetary reward received from an investment. This reward, in the case of stocks, is typically in the form of capital gains (stock price appreciation) and dividends.

Risk and Reward
In the world of investing, the reward that an investor gets depends heavily on the risk that he/she is willing to take on. Government bonds are the least risky and could yield anywhere between 1% and 5% p.a. depending on the maturity of the bond, the issuing government, the currency of issue and the prevailing interest rates. Bonds of robust companies with fairly certain cashflows yield more than government bonds while bonds of companies with poor credit ratings yield even more. Stocks and real estate typically have the highest average return as well as the highest risk(volatility of returns) among all asset classes.

If one desires a high return, she must be willing to take on a high amount of risk. It is improbable that one will consistently be able to find investments with low risk and high return.

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