The Concepts of Return on Investment & Risk

The Concepts of Return on Investment & Risk
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Making investment decisions really boils down to a simple calculation: Is the potential profit you could make from an investment worth the risk you'd have to assume? Profit potential is measured by projected return on investment -- how much you could expect to get back for what you put in. Risk is the uncertainty involved. The two are directly related. An investment that presents high risk needs to offer high potential return to entice investors. A safe, low-risk investment can offers a lower return.

Return on Investment (ROI)

The term refers to how much money is gained or lost after an investment. If you invest $1,000 and get back $1,080, you have an $80 (8 percent) return on the investment.

A negative return looks like this: You invest $1,000 and a year later only $900 remains. Return in this case was negative $100, or negative 10 percent. The percentage is in relation to original amount invested.

Unbalanced Percentages

Gains and losses do not balance out with percentages. For example, $1,000 invested has a -10 percent annual return. So a year later, $1,000 is reduced to $900. Now, if that $900 had a 10 percent positive annual return the year after that, 10 pecent of $900 is $90. Therefore, the total after two years is $990, less than the starting $1,000. The numbers work slightly against the investor even though percentages even out.

Risk: Depreciation Probability

Risk is a comprehensive term. It encompasses probability and magnitude of a loss. Buying stock allows a possibility that amount invested disappears from your account as the company goes out of business. That is bigger risk than buying a well-rated bond in terms of depreciation probability. A well-rated bond is less likely to give negative return on investment than stocks. Therefore, as a general rule, stocks have a higher depreciation probability.

Risk: Depreciation Magnitude

Risk increases if loss exceeds amount invested even if loss probability remains unchanged. Consider short-selling. The likelihood of stock ABC decreasing in value remains the same regardless of buying equity or short-selling. If $1,000 worth of ABC stock doubles in value, a short-seller has to pay $2,000, which is a negative 100 percent ROI. But if ABC stock triples in value, you have to pay $3,000, realizing a negative 200 percent ROI. Magnitude of possible loss is crucial in quantifying risk.

High Risk and Return

Higher risk corresponds to higher returns. Let’s examine what influences bond interest rate. If the seller has a record of success, people will feel comfortable giving the seller money for a promised return later. The seller knows this, and therefore can offer a low rate. A buyer may feel safe and therefore purchase the debt, or not if they decide that the low return isn’t worth having their money tied up with the issuer for years.

Low Risk and Return

By contrast, if the bond issuer has a questionable reliability record, it will take promise of a larger return (a "junk bond") to entice investors. A buyer may be greedy for the possibility of high returns and purchase the bond or decline by deciding the potential payoff isn’t worth the possibility of losing some, if not all, of the original invested amount.