Risk vs.

Return
Narrator: One of the concepts that we run into quite frequently in the world of
finance is the concept of risk versus return. We assume that there is a relationship
between the level of risk associated with a financial activity and the level of
potential or expected return associated with that same activity.

The risk/ return relationships:

The basics:
Levels of risk should equal levels of return for most situations
High risk/ high return
Med risk/ return
Low risk/ low return
The general principle is that levels of risk and levels of return should be equal.
For example, if you undertake a high risk activity, perhaps a very risky investment
of some type, we would expect that there would be a very high level of possible
return associated with that activity, otherwise it would seem like the high risk
would not be justified. You can look at the same relationship for a low risk
activity, and you can reasonably expect a very low level of returns, it’s not very
much risks being taken. We’ll illustrate this with a little activity.

[a graph appears on the slide. On the left side there is a column: A: Result 1-5. B:
Result even#, C: Result 6, D: Result 6. Column middle left: If Successful: Get back
candy plus 1 stick gum, get back 2 candy, Get back 5-8 candy (exact number to be
determined last-minute by market whim), Get back candy plus 1 stick gum.
Column middle right: If Fail: Get back Candy minus ‘commission’, get back ½
candy, Lose candy, Lose candy. Column Right: Risk/Return: Low/low, Med/med,
High/high, High/low]
Let’s assume you’ve been given a candy bar, and the candy bar that you have is
one that’s your favorite and it has great value to you, and you’re interested in
consuming it. But you’re given an opportunity to invest your candy bar with the
possibility of earning a return on it. And let’s say that you have these four options
here as investments. You have option A, option B, option C, and option D. Under
each of these options you’re going to give the candy bar to the market place and
leave it alone for some period of time, and then see what kind of a return you
receive. In order to simulate the uncertainty, or randomness which occurs in all
investment markets, we’ll use a random number generator to generate a number
between one and six. And the resulting number would determine what type of a
return you would get. So let’s look at investment A for example. Investment A, in
order to be successful, you have to receive a random number between one and five.
In other words, the only number that will not give you a positive return is the
number six.
So let’s say you invest in this particular investment A, and you successfully receive
a number between one and five. That means what you’d get back is your candy bar
that you originally invested, plus a stick of gum. If you fail to get the required
numbers, one through five, and instead you roll a six, or you receive a six on your
random number generator, what you’ll get back is your candy bar minus a
commission. So perhaps we would cut the corner of your candy bar off and give it
back to you. This investment is actually what we would call a low risk, low return
investment. There’s not very much risk, it’s very very likely that you’ll get a
number between one and five from the random number generator. And there’s not
very much risk in terms of loss. You’ll lose a little bit of your candy bar, maybe a
little corner of it if something goes wrong. The return is also not very large, it’s
just a stick of gum. So we would call this a low risk, low return investment option.
Option B is a little bit higher risk, you actually have to receive an even number. So
the generator, the random number generator has to come up with a two, a four, or a
six. So about a fifty percent chance of getting one of those numbers. If you
successfully get and even number what you’ll get back is two candy bars. So you
will have actually doubled the value of your initial investment. If you fail and you
receive and odd number, what you’ll get back is half of the candy that you
originally invested. So, you’ll lose half your candy bar. And you might categorize
this as medium risk, medium return investment activity. There is a high risk
alternative here.
It’s C, and what you have to do here is you have to receive a six. The random
number generator has to produce a six in order for you to be successful. If you’re
successful you’ll get a big handful of candy bars back. However many fit in my
hand, five to eight. If you fail to get a six, in other words you get any other number
between one and six, you lose your entire investment, and you lose the whole
candy bar. We would probably characterize this as a high risk, high return
investment. Now we’ve put one other choice on the page here.
That’s investment option D. Look at this one, it still has high risk, and not very
high probability of success, and you have to get a six. If you do get a six, what you
get back is your original candy bar plus a stick of gum. If you fail to get a six, you
lose your entire candy bar. We would call this a high risk, low return alternative.
It’s probably not very attractive to most people.

Imbalances:
Sometimes Risk and return are not equal:
 High risk/Low return: These situations should be avoided by corporate
managers.
 Low risk/High Return: The first reaction by a responsible corporate
manager should be one of skepticism.
This is not a normal state of ‘being’ for a potential investment. A series of deep,
probing questions is warranted in these cases. Is the investment legitimate? Are
there potential risks that have not been properly communicated? (this is common).
This is certainly a worthy goal of any manager: to increase return while
minimizing risk… care must be taken that it is done properly.

So we often times run across situations where risk and return are in fact not equal.
Like the option D candy bar investment that I just showed you where it had very
high levels of risk, you risk losing the entire candy bar. There’s not a very high
chance of success, and if you are successful, return that you get is very small, it’s
just a stick of gum. Occasionally you run into those. Those things should be
avoided. Financially we run into these situations occasionally where we’ll look at
an investment perhaps that has characteristics of high levels of risk, and yet the
potential return just does not seem very attractive.
As a financial manager, one of the things that you’re trying to do is to help
analyze situations and investments and identify those that have the best possible
combination of risk and return.
One of the things that financial managers should try to do is to increase the return
as much as possible while minimizing the risk as much as possible. In a perfect
world, what you might find would be investments that had very low levels of risk
and very high levels of return.
These are very difficult to find, quite often they are cause for suspicion.
But sometimes carefully managing your situation, your costs, and your investment
strategies can actually result in tilting both the risk and the return somewhat in the
favor of your company.