Risk-Return Trade Off

Investing is an efficient and effective way to use personal or business funds. These funds, to be
considered an investment, need to be engaged in profitable activities, otherwise, it will not be investing but
mere expenditure. However, there are certain questions that one may consider before considering an
investment activity.
a. Why is there a need for investment?
b. How much will it cost? How much funds is the investor willing to put into this investment?
c. How big are the chances of gaining or losing from this investment?
d. How long will the investor make hold of this investment?

Investment can be considered as funds that can either multiply or incur a loss. These questions will
help business owners in deciding and choosing the investment with the greatest possible return or gain.

Investment risks are uncertainties or chances that the outcomes of investments are different from
what is expected or projected.
Some examples of investment risks are (Ontario Securities Commission, 2019):

1. Market risk is the uncertainty due to economic development or factors that affect the entire market.
2. Liquidity risk is the chance that an investor is unable to sell an investment due to change in price. The
investor may need to accept a lower selling price.
3. Concentration risk refers to the concentration of loss that can be incurred due to a lack of diversification.
4. Credit risk is the risk that money invested in a government bond may be uncollectible.
5. Reinvestment risk refers to the risk of loss from shifting from one investment to another.
6. Inflation risk is the risk that an investment may not be able to sustain its purchasing power due to
inflation.
7. Horizon risk is the risk that an investment may be stopped or pulled-out due to unforeseen events (loss of
job).
8. Longevity risk is the risk that a person will live too long and may outlive his/her investment/savings.
9. Foreign investment risks are individual market risks that may affect investments from different
countries.

Example: An investor is choosing between acquiring a famous franchise for Php 2.5 million and establishing
her own convenience store at Php 1 million. The risks of acquiring the famous franchise are high because it
costs more than establishing a store from scratch. If each business is under the same condition, a down
economy for example, an investor may lose as much as Php 2.5 million if franchising is chosen.

Investment returns are the expected or projected profits to receive from an investment.

Example: Suppose that the chosen investment is the franchise. Upon analysis, franchising will give the
greatest possible return primarily because of the established market strengths of a well-known business
name. Continuous support can also be provided by the parent company. The weight of handling negative
economic impacts will be well distributed if not avoided. Promotion, branding, and goodwill are also basically
provided and will no longer be a problem to start with. Therefore, higher profits are expected, given these
advantages.
Risk-return Trade Off
In this regard, risk and return are directly related to an investment opportunity. In business, there is a
principle that lower risk tends to give lower returns while higher risk tends to give higher returns . Therefore, in
a risk-return trade off, an investment will yield a higher return only if the investor accepts a higher risk or
possibility of losses (Chen, 2020).
However, not all investors are willing to accept risk the moment it is presented to them. Investors have
different levels of acceptance because it is primarily driven by the availability of resources while balancing the
advantages and disadvantages of investment opportunities. This level of acceptance is called risk tolerance
(Twin, 2020) and is classified into conservative, moderate, and aggressive.

Conservative Risk Tolerance is a characteristic of an investor whose willingness in accepting risks is very
low. This investor will expect to gain profit, with little to no disadvantage to them.

Moderate Risk Tolerance is a characteristic of an investor who is willing to put average resources and accept
some risks. This investor will expect to gain above-average profit, while enduring little disadvantages. This
type of investor is more likely to pull-out an investment (if applicable) whenever risks are uncontrollable.

Aggressive Risk Tolerance is a characteristic of an investor who is willing to put more resources and accept
maximum risks on high-quality investment with high expectation of return. This investor has great knowledge
about the industry and is willing to keep the investment at a longer holding period until investments create
the highest possible return but is prepared for the worst - losing the entire investment.

Portfolio Management

Portfolio management is the planning of investment opportunities based on the risk tolerance of an
investor, to meet the financial objectives at a given time frame. On a more technical term, portfolio
management is used in investment discussions about stocks, bonds, time deposits, and other money market
investments.

Investors have the principle of “putting eggs in different baskets”. This is called an investment
diversification. In cases where the investor has stagnant or excess resources, they engage in different
investing activities to gain profit. It can be used to put up a store, offer credit to borrowers, finance a profit-
making project, or invest in the stock market, time deposit, bonds, and foreign exchange. These “baskets” are
called portfolios. Each portfolio is different in purpose, amount, risks, returns, and time frame. A wise
investor who is maintaining two or more accounts should keep investment portfolios to keep track of the
growth or losses in each investment.

By putting resources into different baskets (diversification), it will reduce or spread the risks of losing
all investments. In this example, the investor funds four investment portfolios. If investment 3 falls, somehow,
the risk of losing all investment is low. But this should not mean that one will let go of investment 3 without
further financial and risk analysis.

It is important that investments have clear financial objectives, no matter how big or small the
investment is. In investing, time should be the investor’s ally because time is one key for funds to grow.
Harvesting too early may be more damaging to your finances and objectives. More than anything else, getting
an investment requires continuous market study to enjoy substantial to maximum profits.
 Activity Sheet

I. Directions: Select the letter of the best answer. Write your answers on a separate sheet of
paper (½ lengthwise).

1. Which is a feasible investment risk?

A. Mark promises investors that he can double their money in 10 years.
B. Mark promises investors that no loss will be incurred in 10 years.
C. Mark does not promise that the investment would grow as much as 10% but will depend
on market situations.
D. All the above

2. Which situation shows an investment return?

A. Sasha invests Php 100,000.00 in a cooperative and gets Php 101,000.00 after a year.
B. Sasha saves Php 100,000.00 in a bank and gets Php 200.00 interest per month.
C. Sasha saves Php 1,000.00 in a coin bank per month.
D. Sasha plans to establish a sari-sari store with her Php 100,000.00.

3. Danny B, is a business owner. For 5 years in the business, he saved Php 500,000.00 in his bank
account. Danny invests a part of this money into a government bond with low risk but low return.
What type of risk tolerance is shown?
A. conservative risk tolerance
B. moderate risk tolerance
C. aggressive risk tolerance
D. low tolerance

4. Which of the following situations shows portfolio management?

A. Mr. Benjie saves money in a coin bank. He owns 10 coin banks overall.
B. Mr. Ali gets Php 50,000.00 from bonus, Php 10,000.00 from commission and Php5,000.00
from his salary.
C. Ms. Ivee won Php 1,000,000.00 from lottery. She saved Php 500,000.00 in a savings
account, put Php 300,000.00 in a time deposit and put up a store for Php 200,000.00.
D. Ms. Rowena has 4 bank accounts; all are payroll accounts. She has been working four
jobs to feed her family.

5. Local prices of farm goods are negatively affected by high importation. Due to this, farmers have
no choice but to accept the lowest market prices for their highly perishable products. What risk is
involved in the situation?
A. market risk C. credit risk
B. inflation risk D. reinvestment risk

II. Directions: Identify the terms being described. Choose your answers from the box below.
Write it on your paper.

Market Risk Investment Returns

Investment Risk Horizon Risk
Concentration Risk Investment Diversification
Reinvestment Risk Foreign Risk
Moderate Risk Tolerance Risk-Return Trade Off

1. It refers to the risk of loss from shifting from one investment to another.
2. It is the uncertainty due to economic development or factors that affect the entire market.
3. These are individual market risks that may affect investments from different countries.
4. This refers to the concentration of loss that can be incurred due to lack of diversification.
5. It is the risk that an investment may be stopped or pulled-out due to unforeseen events (loss of
job).
6. These are uncertainties or chances that the outcomes of investments are different from what is
expected or projected.
7. These are the expected or projected profits to be received from an investment.
8. It is a principle that lower risk tends to give lower returns while higher risk tends to give a higher
return.
9. It is a characteristic of an investor who is willing to put average resources and accept some risks.
10. It is the principle of “putting eggs in different baskets”.