Return is the reward from an investment, while risk is the uncertainty surrounding that return. Finance decisions compare expected return with the amount and type of risk an investor must accept.
What is investment return?
Total return combines income received with the change in the asset's value. For a share, income may be a dividend and the price change may create a capital gain or loss.
A share purchased for 100 pays a dividend of 4 and ends the year at 108. The return is (4 + 108 − 100) ÷ 100 = 12%.
Expected return
When several outcomes are possible, multiply each return by its probability and add the results.
| Economic state | Probability | Possible return | Weighted return |
|---|---|---|---|
| Weak | 0.25 | −8% | −2.0% |
| Normal | 0.50 | 12% | 6.0% |
| Strong | 0.25 | 28% | 7.0% |
| Expected return | 1.00 | — | 11.0% |
Measuring total risk
Variance measures the probability-weighted squared distance from expected return. Standard deviation is the square root of variance and is expressed in the same units as return.
Standard deviation = √Variance
For the probability example, the standard deviation is approximately 12.8%. An expected return of 11% therefore comes with meaningful uncertainty.
Risk and return relationship
Investors normally require higher expected returns for bearing greater relevant risk. This does not mean a risky asset will actually earn more. The higher return is an expectation or required compensation; realised outcomes can be lower or negative.
Systematic and unsystematic risk
| Risk type | Source | Can diversification reduce it? |
|---|---|---|
| Systematic risk | Economy-wide forces such as interest rates and recessions | Not fully |
| Unsystematic risk | Company or industry-specific events | Yes, through a diversified portfolio |
Because investors can diversify company-specific risk, market-based models usually focus on systematic risk when estimating required return.
Comparing investments
Standard deviation alone can mislead when expected returns differ. The coefficient of variation—standard deviation divided by expected return—can compare risk per unit of expected return, but it also has limitations when expected return is close to zero or negative.
Practical analysis checklist
- Use total return, including income and price change.
- Separate expected return from realised return.
- Review downside outcomes, not only the average.
- Identify which risks can be diversified.
- Match the time horizon and assumptions across alternatives.
Frequently asked questions
Does higher risk guarantee higher return?
No. It may justify a higher expected or required return, but the realised return can be much lower.
What does standard deviation measure?
It measures how widely possible or historical returns vary around the average return.
Can diversification remove every risk?
No. It can reduce company-specific risk, but broad market risk remains.
What is the difference between expected and realised return?
Expected return is a probability-based forecast. Realised return is the result that actually occurred.
Continue learning
- Bond and share valuation
- Cost of equity and CAPM
- Risk analysis in capital budgeting
- Portfolio management
Use the formulas and examples as learning tools. Real decisions should use reliable data, appropriate assumptions and professional judgment where necessary.
Risk and return are most important concepts in finance. In fact, they are the foundation of the modern finance theory.
What is the risk? How is it measured? What is return? How is it measured? How are assets valued in capital markets? How do investors make their investment decisions? We are going to discuss these questions in our future posts.
Return on a single asset
Total return = Dividend + Capital gain
Unrealized capital gain or loss
If an investor holds a share and does not sell it at the end of the period, the difference between the beginning and ending share prices is the unrealized capital gain or loss.
The investor must consider the unrealized capital gain or loss as part of his total return. The fact of the matter is that if the investor so wanted, he could have sold the share and realized the capital gain or loss.
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