Risk Return Ratio Example

How Risk Return Ratio works? To manage risk effectively, it is important to understand the relationship between risk and return. I’ll try to explain the risk return ratio as easily as possible. Generally, the more risk you are willing to assume, the higher the potential for reward. Therefore, establishing realistic expectations for return is an integral part of assessing your risk tolerance.
The risk Risk/Return Chart below compares the historical risk vs. performance relationship of the capital markets. The vertical axis indicates rates of return, and the horizontal axis indicates risk. The further right your portfolio falls, the more volatility it is likely to undergo in periodic returns. The closer to the top of the graph your portfolio is, the higher the return. The relationships indicated here generally reflect a complete market cycle.
A volatility number is the percentage change expected to contain the annual move in a stock or an index, two-thirds of the time. A volatility number of 17 for a stock or index means that two years out of three, the stock or index may fall as much as 17%, or perhaps in the same year, rise 17% from where it is now.
Risk over Return Ratio Example

Return over Risk Ratio

Capital preservation

oriented

Capital appreciation

oriented

Agressive growth

oriented

Total return oriented

but may nave higher

current income

Minimal income needs

No current income

consideration

Increasing equity

exposure and portfolio

volatlity

Greater volatility than

broad stock market

Suitable for short time

horizon (theree to five

years)

Longer time horizon –

at least a market cycle

Longest time horizon

(ten years or more)

As the Risk/Return Chart illustrates, the relationship between risk and return that characterizes specific investments can be quantified. By measuring your risk tolerance and return objectives, your investment advisor can help you choose the type of investment style and securities most closely attuned to your needs and risk tolerance.

Investor A uses the most conservative instruments, i.e. mainly investment grade bonds and cash equivalents, such as money market funds and Treasury Bills. These instruments have a low market investment risk and, unfortunately, a low return. Investor A is definitely oriented toward capital preservation and is a risk avoider.
Investor B diversifies investment risk by investing in a balanced combination of stocks, bonds and cash equivalents, such as money market funds and Treasury Bills. The balanced approach seeks to reduce volatility and maximize total return, the combination of capital appreciation and income.

Investor C, an asset allocator, seeks to maximize returns by actively adjusting the portfolio’s mix of stocks, bonds and cash equivalents in anticipation of trends and stock market direction. At any given time the portfolio may be 100% invested in a single asset class that the asset allocator believes will perform best.

Investor D uses stocks of the Standard and Poor (S&P 500) companies predominately, but may also use cash equivalents to reduce portfolio volatility. The S&P 500 are large capitalization issues which are typically, more than two billion dollars, i.e. value of the first is calculated by multiplying the number of shares issued and outstanding by their latest market price, investor D uses a value style. Value investors attempt to identify companies whose inexpensive stock prices do not reflect their potential values. By buying and holding such stocks, value-oriented investors hope to sell them when their stock prices become fully valued or even overvalued. The value approach is considered a conservative strategy; while these stocks tend to lag in strongly advancing markets, they often outperform in declining markets.

Investor E is aggressive and uses stocks exclusively by investing in large and medium core growth stocks (capitalization of $500 million to $2 billion). Investor E uses a growth style. Growth-oriented investors favor companies and industries that have experienced above-average growth in sales and earnings and are expected to continue a high pace of profit growth in the future. When selecting specific investments, growth-oriented investors try to determine whether a company’s shares are reasonably priced in relation to its future potential. Growth stocks tend to pay low dividends and, therefore, are generally inappropriate for income-oriented portfolios.

Investor F is the most aggressive and invests in small capitalization companies, i.e. up to $500 million. He remains fully invested under all market conditions in companies believed to be growing rapidly. These companies are relatively small and new to publicly traded markets. Aggressive growth stocks are most often listed on the over-the-counter exchanges, such as NASDAQ. These companies tend to pay low or no dividends and are inappropriate for income oriented portfolios. Aggressive growth portfolios are most suitable for long-term investors who can tolerate huge price fluctuations. Investors using this style believe that the rewards of aggressive growth investing will be commensurate with its risks over the long-term.

Equity oriented investors (investors C through F) sometimes include in their equity portfolios international securities. In such cases they buy securities in international markets, including Europe, Asia, South America, etc.

More here: Wikipedia, Investopedia.