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The tradeoffs between return and risk

The discussion of financial investments has emphasized the expected rate of return, the risk, and the liquidity of each investment. [link] summarizes these characteristics.

Key characteristics for financial investments
Financial Investment Return Risk Liquidity
Checking account Very low Very little Very high
Savings account Low Very little High
Certificate of deposit Low to medium Very little Medium
Stocks High Medium to high Medium
Bonds Medium Low to medium Medium
Mutual funds Medium to high Medium to high Medium to high
Housing Medium Medium Low
Gold Medium High Low
Collectibles Low to medium High Low

The household investment choices listed here display a tradeoff between the expected return and the degree of risk involved. Bank accounts have very low risk and very low returns; bonds have higher risk but higher returns; and stocks are riskiest of all but have the potential for still higher returns. In effect, the higher average return compensates for the higher degree of risk. If risky assets like stocks did not also offer a higher average return, then few investors would want them.

This tradeoff between return and risk complicates the task of any financial investor: Is it better to invest safely or to take a risk and go for the high return? Ultimately, choices about risk and return will be based on personal preferences. However, it is often useful to examine risk and return in the context of different time frames.

The high returns of stock market investments refer to a high average return that can be expected over a period of several years or decades. The high risk of such investments refers to the fact that in shorter time frames, from months to a few years, the rate of return may fluctuate a great deal. Thus, a person near retirement age, who already owns a house, may prefer reduced risk and certainty about retirement income. For young workers, just starting to make a reasonably profitable living, it may make sense to put most of their savings for retirement in stocks. Stocks are risky in the short term, to be sure, but when the worker can look forward to several decades during which stock market ups and downs can even out, stocks will typically pay a much higher return over that extended period than will bonds or bank accounts. Thus, tradeoffs between risk and return must be considered in the context of where the investor is in life.

Key concepts and summary

All investments can be categorized according to three key characteristics: average expected return, degree of risk, and liquidity. To get a higher rate of return, an investor must typically accept either more risk or less liquidity. Banks are an example of a financial intermediary, an institution that operates to coordinate supply and demand in the financial capital market. Banks offer a range of accounts, including checking accounts, savings accounts, and certificates of deposit. Under the federal deposit insurance program, banks purchase insurance against the risk of a bank failure.

A typical bond promises the financial investor a series of payments over time, based on the interest rate at the time the bond is issued, and then repayment of what was borrowed. Bonds that offer a high rate of return but also a relatively high chance of defaulting on the payments are called high yield or junk bonds. The bond yield is the rate of return that a bond promises to pay at the time of purchase. Even when bonds make payments based on a fixed rate of interest, they are somewhat risky, because if interest rates rise for the economy as a whole, an investor who owns bonds issued at lower interest rates is now locked into the low rate and suffers a loss.

Changes in the price of a stock depend on changes in expectations about future profits. Investing in any individual firm is somewhat risky, so investors are wise to practice diversification, which means investing in a range of companies. A mutual fund purchases an array of stocks and/or bonds. An investor in the mutual fund then receives a return depending on the overall performance of the investments made by the fund as a whole. A mutual fund that seeks to imitate the overall behavior of the stock market is called an index fund.

Housing and other tangible assets can also be regarded as forms of financial investment, which pay a rate of return in the form of capital gains. Housing can also offer a nonfinancial return—specifically, you can live in it.

Problems

Imagine that a $10,000 ten-year bond was issued at an interest rate of 6%. You are thinking about buying this bond one year before the end of the ten years, but interest rates are now 9%.

  1. Given the change in interest rates, would you expect to pay more or less than $10,000 for the bond?
  2. Calculate what you would actually be willing to pay for this bond.

Got questions? Get instant answers now!

Suppose Ford Motor Company issues a five year bond with a face value of $5,000 that pays an annual coupon payment of $150.

  1. What is the interest rate Ford is paying on the borrowed funds?
  2. Suppose the market interest rate rises from 3% to 4% a year after Ford issues the bonds. Will the value of the bond increase or decrease?

Got questions? Get instant answers now!

References

Howley, Kathleen M. Bloomberg. “Home Value Highest Since ’07 as U.S. Houses Make Cash.” Last modified March 26, 2013. http://www.bloomberg.com/news/2013-03-26/home-value-highest-since-07-as-u-s-houses-make-cash-mortgages.html.

NASDAQ.com. 2015. “Facebook, Inc. Historical Stock Prices.” Accessed March 28, 2015. http://www.nasdaq.com/symbol/fb/historical.

National Association of Realtors. 2015. “Existing-Home Sales: Latest News.” Accessed April 1, 2015. http://www.realtor.org/topics/existing-home-sales/data.

PricewaterhouseCoopers LLP. 2015. “Annual Venture Capital Investment Tops $48 Billion in 2014, Reaching Hightest Level in Over a Decade, According to the Moneytree Report.” Accessed April 1, 2015. http://www.pwc.com/us/en/press-releases/2015/annual-venture-capital-investment-tops-48-billion.jhtml.

Rooney, Ben. “Trading Program Sparked May ‘Flash Crash’.” CNN Money . Last modified October 1, 2010. http://money.cnn.com/2010/10/01/markets/SEC_CFTC_flash_crash/index.htm.

Investment Company Institute. “2013 Investment Company Fact Book, Chapter 6: Characteristics of Mutual Fund Owners.” http://icifactbook.org/fb_ch6.html.

Questions & Answers

what's different macroeconomic and microeconomic
Kibrom Reply
What would be the impact on Debt repayment?
Salman Reply
I don't know.
Kulbir
Plz help me
Salman
Repayment is act of paying back money previously borrowed from lender . And as we know that repayment term of loans also includes intrest rate . So the more early debt will be repayed the less rate of intrest we will have to pay .
Palak
what is different between customer behaviour and consumer behaviour?
Chhaya Reply
costumers are simply those who sells a product or service while consumers are said to be the buyers of the product or service and paying for it.
Aditi
what is scarcity
Chhaya Reply
This are your limited resources/goods.
Oluwatobiloba
scarcity in economic mean when the resources(goods&services) are limited to meet the demands of the people. in other words shortage of goods and services.
Gatwich
what is choice
Chhaya Reply
what is scarcity
Chhaya
Scarcity refers to resources being finite and limited. Scarcity means we have to decide how and what to produce from these limited resources. It means there is a constant opportunity cost involved in making economic decisions. eg. Land, water, labour etc.
Kevin
what is price in economics
Affoh
difference between monopoly anad monopolistic copmitition
sriram Reply
do you mean monopolistic competition?
Krshol
Monopoly is a form of market where there is only one seller of the product or service like in case of railways in India while a monopolistic competition refers to a situation where there are more than 1 seller of products having products with little product differciation.
mir
any one tell plz mean this question What is the main complement of peanut butter and what do you predict happened in its market in 2011?
Sajjad
thank you Muteeba
sriram
when the total revenue graph is above total cost what does it means
Jeff Reply
i have no idea, someone get the answer ?
Khairul
it means that the goods and services that was sold in the firm were a lot and has quality and the prices were high
pombili
cool
Jeff
it means there are profits because returns are more than costs
Danisa
I agree with Danisa, the producer has a Surplus which equals to total Revenue minus total Cost. Conceptually, it is the revenues that firms get above and beyond their costs. It is also known as Total Profit.
Lily
so simple, it's the profit.
Andrush
if the industry price is fixed at N$ 120, how will the calculation of the firm's profit maximizing level of output be?
Leo Reply
economics loss would lead to firms exiting tje market in tje short run?
Jhapet Reply
how do you calculate maximum achievable profit if you are told that industry price is fixed at $120
pombili Reply
how do you calculate profit maximize level of output if the industry price is fixed at N$120?
Simeon
what does this mean other things remain unchanged
Mohib Reply
It means that we assume one factor variable and other factors constant. It is known as ceteris paribus.
Vibhu
it means all the factors like fashion, season, techniques, related goods etc are constant . means there is no change.. we assume that only one factor = price affect dd quantity demand or supply.
Neha
In a perfectly competitive market, a short-run equilibrium cannot continue in the long-run if: A. The firm's are earning zero economic profits. B. the firm's are earning normal profits. C. The firm's are making economic losses. D. The firm's are operating at minimum average cost E. All of the above
Esihle Reply
c
Affoh
C is the answer.
Oluwatobiloba
the difference between marginal utility and diminishing marginal utility
ANNELI Reply
some times marginal utility increases but marginal dimnishing always decreases or diminishes
Waseem
when you are willing to spend a maximum amount of $ for an extra unit of "something" you want is marginal utility, but then when you bought enough of that "something" and you are not willing to pay that max amount of $ for an extra unit that is when its utility decreases and you have dim. Marg. util
Lily
Using diagrams, show the effect on the demand curve, supply curve, the equilibrium price and the equilibrium quantity of each of the following events The salaries of journalists go up
Secilia Reply
demand increases and price
Vishesh Reply
is this referred to the law of demand? quantity and cost are negatively related so if the demand increases the price decreases.
Lily
An increase I demand leads to an increase in price and vice versa, this is the law of demand and supply
Musyoka
what is the question ?
OK
how about demand curve affect economy?
ally
I don't know about conversation btn Lily Oro and Musyoka Clement? how main topic concerned, Lily may u give clarification on that in deep we can learn from you!!!
ally

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Source:  OpenStax, Microeconomics. OpenStax CNX. Aug 03, 2014 Download for free at http://legacy.cnx.org/content/col11627/1.10
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