Risk and Return Analysis

Return expresses the amount which an investor actually earned on an investment during a certain period. Return includes the interest, dividend and capital gains; while risk represents the uncertainty associated with a particular task. In financial terms, risk is the chance or probability that a certain investment may or may not deliver the actual/expected returns.

The risk and return trade off says that the potential return rises with an increase in risk. It is important for an investor to decide on a balance between the desire for the lowest possible risk and highest possible return.

Risk Analysis

Risk in investment exists because of the inability to make perfect or accurate forecasts. Risk in investment is defined as the variability that is likely to occur in future cash flows from an investment. The greater variability of these cash flows indicates greater risk.

Variance or standard deviation measures the deviation about expected cash flows of each of the possible cash flows and is known as the absolute measure of risk; while co-efficient of variation is a relative measure of risk.

For carrying out risk analysis, following methods are used-

• Payback [How long will it take to recover the investment]

• Certainty equivalent [The amount that will certainly come to you]

• Risk adjusted discount rate [Present value i.e. PV of future inflows with discount rate]

However in practice, sensitivity analysis and conservative forecast techniques being simpler and easier to handle, are used for risk analysis. Sensitivity analysis [a variation of break even analysis] allows estimating the impact of change in the behavior of critical variables on the investment cash flows. Conservative forecasts include using short payback or higher discount rates for discounting cash flows.