Brief Overview on Risk and Reward
Brief Overview on Risk and Reward
Brief Overview on Risk and Reward
Let's say you are watching a football game on television. The score is all tied up, the ball is on the opposing team's forty yard line, and it's forth down and only a few inches to go. The coach has to make a decision on what to do. He is left with a few different options, each option carrying different levels of risk and reward. One option would be to minimize the risk of turning the ball over and simply punt the ball away to the other team. This would be the safest decision but limited reward because you are giving the ball to the other team. Another option would be to have your team kick the long field goal, from this distance it would be a risky decision but it could result in three points. The last option and the most risky of the three would be to go for it in hope of getting a new set of downs. This could potentially lead to a closer field goal attempt or even a touchdown worth seven points. In these examples the more risk involved the more rewarding the outcome may be.
Investment decisions are very similar. Different investment opportunities have different levels of risk and reward. In general terms, the wider the range of outcomes, the greater the risk may be. Additionally if the range of outcomes is greater, it may lead to a higher return. So if you are left with an investment opportunity, you should take risk and reward into consideration. The good news is that there are formulas and calculations you can do to help you decide if an investment is right for you.
One thing you should look into is the rate of return. Rate of return is the percentage calculated by dividing the amount of return on an investment for a period of time by the average amount of invested for the same period. This is a primary measure of profitability. The formula is below.
Rate of Return = Amount of return / Amount invested
Here is an example of how you could use this formula. Let's say you invested $5,000 into an investment which returned an income of $400 and you wanted to know what your rate of return was.
$400 / $5,000 = 8% Rate of Return
You could also use this formula to compare two different investments to find out which investment is more rewarding based on the different returns. Another option is to rearrange the formula if you had the rate of return and wanted to calculate the amount of return you would receive based on the amount that you invested.
Amount Invested x Rate of Return = Amount of Return ($5,000 x 8% = $400)
This should look very similar to the common formula of "Interest = Principal x Rate". This is because the Rate of Return calculation is derived from the interest calculation. In the Rate of Return calculation, time is considered to be one year, so it is removed.
Rate of Return may or may not always be known.
Investments such as savings accounts, money market accounts, and certificates of deposit are safer investments because the rate of return (interest) is known. Since the rate of return is known these types of investments have little or no risk.
If the rate of return is unknown, for example an investment in a stock, the risk is much greater. Since the risk is much greater investors usually anticipate or hope for a higher rate of return. Of course, due to the risk, the stock investment may yield less of a return than the savings account or quite possibly a negative return. This also explains that the wide range of possible outcomes creates more risk.
Another calculation to look into when analyzing an opportunity is the Return on Investment (ROI). ROI is calculated by using net income and the average of the total assets from the financial statement. This is an important calculation because it shows the rate of return based on the assets available during the year. It is important to note that since net income is based on a full fiscal year's performance, an average of the assets reported at the beginning of the fiscal year and the assets reported at the end of the fiscal year must be calculated. The return on investment calculation is below.
Return on investment = Net Income / Average total assets
You can also use income from operations to calculate your return on investment. Both are correct.
Return on investment = Operating Income / Average operating assets
Knowing the return on investment is important to help you make decisions on the value and profitability of the business.
To conclude, different investments bring on different levels of risks. It is important to know the risks and be able to analyze your investments and returns.
Source:
Marshall, David H., Wayne W. McManus, and Daniel F. Viele. Accounting: What the Numbers Mean. Boston: McGraw-Hill Irwin, 2008. Print.
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