Overview: Risk And Return Go Together—You Must Understand Th ✓ Solved
Overview risk And Return Go Together You Must Understand This
Risk and return go together. You must understand this relationship to make informed financial decisions. This applies when you make personal investment decisions or when you’re investing excess cash for a business. In this journal assignment, you will explore the risk-return relationship when investing in stocks.
Write a journal discussing risk and return as it relates to investing in stocks. Specifically, you must address the following:
- Investment Risk: Explain key risks associated with investing in stocks.
- Investment Return: Discuss events that can cause the price of a stock to increase or decrease.
- Risk-Return Relationship: Explain the relationship between risk and return and how this relationship affects stock-investment decisions. Use examples to support your claims.
- Reflection: Describe how you would make stock-investment decisions in your personal life. Also talk about how your decision-making process might change if you needed to make stock-investment decisions for a business.
Your submission should be a 4- to 5-paragraph Word document with 12-point Times New Roman font, double spacing, and one-inch margins. Sources should be cited according to APA style.
Paper For Above Instructions
Understanding the relationship between risk and return is fundamental to making informed financial decisions, particularly in the context of stock investments. This journal entry will explore the key risks associated with investing in stocks, the potential returns from such investments, the integral risk-return relationship, and personal reflections on making investment decisions both personally and for a business.
Investment Risk
Investing in stocks inherently involves various risks that investors must understand and evaluate. One primary risk is market risk, which is the potential for a loss due to fluctuating market prices. Factors contributing to market risk include economic downturns, changes in consumer behavior, and broader geopolitical issues. According to Sharpe (1964), market risk is a systematic risk that cannot be diversified away, making it crucial for investors to assess their risk tolerance.
Another significant risk is company-specific risk, which pertains to factors that can affect a particular company’s stock price. This includes poor financial performance, management changes, and regulatory challenges. For example, if a technology company were to face a lawsuit over its product's safety, its stock price could plummet, reflecting investor concerns about future earnings (Fama, 1970).
Furthermore, liquidity risk is essential to consider; it refers to the risk of not being able to sell a stock without incurring significant losses. Stocks of smaller companies typically present higher liquidity risk, as they may not have the same trading volume as larger established corporations (Brealey & Myers, 2017).
Investment Return
Investment returns can vary based on numerous events and factors that influence stock prices. One major driver of stock price appreciation is positive earnings reports; when companies announce better-than-expected earnings, their stock prices often surge. Conversely, disappointing earnings can lead to price declines. For instance, Apple Inc. consistently demonstrates how solid quarterly earnings can propel its stock higher, while any adverse news regarding sales or product recalls can lead to significant drops in market value (Graham & Dodd, 2008).
Other events impacting stock prices include macroeconomic indicators like interest rate changes and inflation rates. When the Federal Reserve raises interest rates, borrowing becomes more expensive, which can negatively impact consumer spending and corporate profits, causing stock prices to fall (Merton, 1980). Additionally, geopolitical events such as trade wars or natural disasters can create uncertainty in markets, thus affecting stock valuations.
Risk-Return Relationship
The risk-return relationship describes the principle that potential return rises with an increase in risk. Higher-risk investments typically offer the possibility of higher returns. This phenomenon is often illustrated using the Capital Asset Pricing Model (CAPM), which states that the expected return of an asset is equal to the risk-free rate plus the asset's beta multiplied by the market risk premium (Fama & French, 1992). This means investors must evaluate their comfort with risk and the corresponding potential rewards when considering stock investments.
Investors often use this relationship to guide their investment strategies. For example, an investor seeking high returns may be more inclined to invest in emerging market stocks, accepting the potential for high volatility, while a more risk-averse investor may opt for blue-chip stocks with lower return expectations but also less price fluctuation (Elton & Gruber, 1997).
Personal Reflection
In my personal investment decisions, I prioritize a balanced approach to risk and return. Understanding the threats and opportunities within market dynamics allows me to select stocks that align with my long-term financial goals. To mitigate risks, I diversify my portfolio across sectors and asset classes, ensuring that I am not overly reliant on the performance of a single stock or sector.
If I were tasked with making stock-investment decisions for a business, my approach would shift slightly. While I would still consider diversification, I would place greater emphasis on the company's strategic goals and operational metrics. Business decisions would require a detailed analysis of risks associated with the company's market positioning and competitive landscape. Additionally, I might involve stakeholders to ensure that the investment aligns not just with financial objectives but also with corporate values and missions.
Conclusion
In summary, understanding the risk-return relationship is vital for any investor. By recognizing the various risks associated with stock investments, the events that can impact stock prices, and the dynamics of the risk-return relationship, I can make more informed investment decisions. Whether investing personally or on behalf of a business, applying these principles will enhance my ability to navigate the complexities of the stock market.
References
- Brealey, R. A., & Myers, S. C. (2017). Principles of Corporate Finance. McGraw-Hill Education.
- Elton, E. J., & Gruber, M. J. (1997). Modern Portfolio Theory, 1950 to Date. Journal of Banking & Finance, 21(11-12), 1743-1759.
- Fama, E. F. (1970). Efficient Capital Markets: A Review of Theory and Empirical Work. The Journal of Finance, 25(2), 383-417.
- Fama, E. F., & French, K. R. (1992). The Cross-Section of Expected Stock Returns. The Journal of Finance, 47(2), 427-465.
- Graham, B., & Dodd, D. L. (2008). Security Analysis: Sixth Edition. McGraw-Hill Education.
- Merton, R. C. (1980). On Estimating the Expected Return on the Market: An Exploratory Investigation. Journal of Financial Economics, 8(4), 323-361.
- Sharpe, W. F. (1964). Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk. The Journal of Finance, 19(3), 425-442.