Risk and Return & Forms of Returns

Risk and Return
Risk and Return is one of the fundamental concepts under Asset Allocation. The higher the return you expect you expect on an investment, the higher the risk you much be prepared to take. It is an inescapable investment axiom and truth, as the Tables below illustrates:

ASSET...................................................................AVERAGE RETURNS
Ghana stock exchange...................................................................35.2%
Ghana government treasury bills ...................................................2.79%
Bank savings account .....................................................................6.4%
Source: Ghana Stock Exchange, Ministry of Finance and Economic Planning, Ghana and Bank of Ghana – 2008

ASSET...................................................................AVERAGE RETURNS
US Small-Company Stock............................................................ 13.5%
US government treasury bills .........................................................4.3%
Bank savings account .....................................................................6.4%
Source: www.financialsense.com, www.capitalone.com

Of course, greater risk does not guarantee greater return. If it did, you would always choose high-risk investment. ''After all', you might say, ' the higher-return investment carry more risk, but I'm certain to be well reward – just look at the tables.'

The returns shown on the tables, though, are average returns of assets in those categories. The tables really illustrates the fact that, as the expected average return from an investment rises, the range of possible returns also expands

Now that we have seen how risk and return relate to one another, let's us look at the different kinds of returns.

Forms of Returns
You can expect two types of return from any investment: current income and appreciation.
Current income is the amount of cash an investment generates on a regular basis. Various kinds of investments provide current income. so-called dept instruments – Treasury bills, savings accounts, bonds and similar investments, in which you're really loaning money to the government or to a financial institution – pay interest at regular intervals. This is current income.
Stocks generate current income in the form of dividends. And real-estate investments can produce current income in the form of rent.

Appreciation, on the other hand refers to the increase in the price of an investment from the time you buy it until you sell it. Of course the price doesn't have to rise; it can fall as well. This unfortunate event is known as depreciation (not to be confused with depreciation as the word is used in accounting and taxes).
An investment's from of return – current income and appreciation (or depreciation) – is, as we shall now see, closely related to its degree of risk.

The Relationship of the Form of Return to Risk
Generally, the more an investment depends on current income to generate a return- and the less it depends on appreciation – the less risky it is. In other words, betting on future growth is riskier than collecting dividends and interest as you go.

The reason: you know an investment that pays current income will usually return at the very least, a specific sum at regular interval (barring unforeseen circumstances of course)
So a dividend-paying blue-chip stock is less risky than a non dividend –paying growth stock. A certificate of deposit carries less risk than a zero-coupon corporate bond.

But what, exactly, do we mean by risk? In fact, there are several different kinds of risks and that will be the focus on my next series of posts

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