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Return and Risk from All Investment Decisions

There are two aspects that need to be considered by the company's management in making
financial decisions, namely the rate of return and the risk of these financial decisions. The rate of
return is the expected return in the future, while risk is defined as the uncertainty of the expected
return. Risk is the possibility of deviation from the average of the expected rate of return which
can be measured from the standard deviation using statistics.

Understanding Risk and Rate of Return

Risk can be said as an opportunity for loss or destruction. More broadly, risk can be defined as
the possibility of an undesirable or opposite outcome from being desired. In the financial
industry in general, there is a term "high risk brings about high return", meaning that if you want
to get bigger returns, you will be faced with greater risk. Risk and return is a condition
experienced by companies, institutions, and individuals in investment decisions, namely, both
losses and profits in an accounting period.
The relationship between risk and rate of return is:
1. Is linear or unidirectional.
2. The higher the rate of return, the higher the risk.3. The greater the assets that we place in
investment decisions, the greater the risk arising from these investments. Linear conditions are
only possible in normal markets.

In the preparation of the capital budget, an investment project (business expansion / replacement
of fixed assets) often fails after the project is implemented. This happens due to not taking into
account the elements of risk in it. For example: the risk of cash flow in the discount factor as the
cost of capital. If the existing cash flow is obtained in the future there is no risk, it means that we
can determine the right decision to be taken. This is because the budget that we prepare for both
cash inflows and cash outflows is considered certain to occur in the future.

Investment risk can be interpreted as the possibility of a difference between the actual return and
the expected return, so that every investor in making investment decisions must always try to
minimize the various risks that arise, both short term and long term. Every change in economic
conditions, both micro and macro, will encourage investors to carry out strategies that must be
applied to keep getting returns.

Relationship Characteristics of Risk and Return

The greater the probability that the actual return will be far below the expected return and the
greater the stand-alone risk associated with the asset. The average investor is risk averse,
meaning that the investor must be compensated for engaging in risky assets. Therefore, a higher
risk asset has the required return than a less risky asset.

According to Paul L. Krugman and Maurice Obstfeld that in fact, a risk-neutral investor tends to
take the maximum aggressive position. It will buy as many high-yielding assets as possible and
sell as many lower-yielding assets as possible. This behavior creates the conditions for interest
rates.

Risk Calculation
For your information, the smallest risk is bonds sold by the government. While the highest risk is
the shares sold by the company. There is a risk calculation model that is most often used,
especially in investment, namely the standard deviation and variance. To complete this
calculation to be more comprehensive, especially if a problem arises such as the spread of the
expected return is very large, then additional calculations are used using the coefficient of
variation or relative risk.

Return Calculation
In everyday language, return is the rate of profit. Suppose we buy a stock at a price of Rp.
1,000.00, then one year later we sell it at a price of Rp. 1,200.00. The company paid a dividend
of Rp. 100.00 in that year. What is the level of profit or return on the investment?
The profit rate is calculated as follows.
Return = ( Rp.1,200,00 + Rp.100,00 - Rp.1,000.00 ) × 100%
Rp.1,000.00
= ( Rp.300,00 / Rp.1,000.00 )× 100%
The period can be daily, monthly, or yearly. In the example above, the period is yearly. Thus, in
the example above, we can say, the investor earns a profit of 30% per year.

There are several sources of risk that can affect the amount of investment risk, including:
1. Interest rate risk, namely the variability in security returns from changes in interest rates it is
affects bonds directly compared to common stock
2. Market risk, namely the variability of returns from fluctuations in the overall market, for
example the aggregate stock market
3. Inflation risk, one of the factors that affects all securities is the risk of purchasing power or
reduced ability to buy investments
4. Business risk, namely the risk that arises when conducting a business/business in a specific
industry
5. Financial risk, namely the risk associated with the use of debt by the company.
6. Liquidity risk, is the risk associated with the secondary market in securities trading

An investment that can be bought or sold quickly and without significant prices is usually liquid,
the more uncertain the time element and price concessions, the greater the liquidity risk,
exchange rate risk (return variability caused by currency fluctuations), and country risk (also
known as political risk, which is an important risk for investors today. With many investors
investing internationally, either directly or indirectly, the stability and viability of a country's
economy need to be considered) and many more another source of risk.

To reduce risk, investors need to diversify. Diversification shows that investors need to form
investment portfolios in such a way that risk can be minimized without reducing the expected
return. Reducing risk without reducing return is the goal of investors in investing. Generally,
investors can buy or invest their funds with a risk-free rate of return, namely by buying Bank
Indonesia Certificates (SBI). But investors must borrow with returns that are higher than the risk-
free rate of return.

If investors can only buy risk-free assets, but not borrow at a risk-free rate, there are 3
alternatives that can be done, namely:
a. Invest all their capital into risk-free assets by getting a definite rate of return of RBR.
b. Invest all their capital into an efficient portfolio of risky assets at point S by getting an
expected return of E(Rs) with a risk of s.
c. Invest some of their capital into risk-free assets and partly into an efficient portfolio of risk-
free assets and partly into an efficient portfolio of risky assets with an expected return of higher
than RBR but smaller than E(Rs) or RBR < E(Rp) < E( Rs). While the risk obtained is 0 < p < s.