Risk is the potential that the actual return on investment will not be the same as expected. It is the possibility or chances of losing either some, or all, of your original investment.
In finance, the relationship between return and risk is ideally defined as: higher the risk, higher the returns. The reason is that the investor should be compensated for initiating and taking on greater risk. However, taking on greater risk doesn’t always mean that the investor will end up with bigger returns.
How the investor manages and mitigates risk when developing their investment portfolio is also a technique/art that an investor must learn and master to minimize risk, while maximizing returns.
Generally, a treasury bond is less risky as compared to corporate bond. And this is exactly why the rate of return on a treasury bond is lower than a corporate bond. Unlike a treasury bond that is issued by the government, a corporate bond is higher in risk because it is issued by a corporation which has higher chances of going bankrupt.
How Risk is measured?
Risk in finance is measured by taking out the standard deviation of the average returns or historical returns of a given investment. Here’s the formula to compute standard deviation:
Standard deviation acts as a measure of how much the stock price swings high and low in comparison to its average price.
Low Risk Stocks vs. High Risk Stocks
A low risk stock will have small swings and therefore will be easier to predict in terms of trends and returns. However, a risky stock is unpredictable and has larger swings. Since it is hard to predict returns and trends of a stock with high risk, it is therefore advisable to get out during a high. This will not just help you make big profits but also enable you to mitigate risk.
Time Horizon- An Important Factor When Making Investments
When it comes to investing, time horizon plays a vital role. It is defined as the length of time that you can part with your invested money before you need it again. Therefore, you must know whether you’re investing for short-term or long-term.
A long term horizon gives you, the investor, the ability to lay out any large dips, allowing you to have more risky investments. However, if you plan on taking out your money in a year, you would eventually have a short term horizon and you might even be forced to withdraw from your investment during a dip.