Understanding how risk affects investment returns is really important for university students studying finance. Here’s why:

1. Risk and Return

• There is a basic idea in finance: the more risk you take, the bigger the possible reward.
• For example, data from 1926 to 2020 shows that the average yearly return for the S&P 500 is around 10%. But this also means there can be a lot of ups and downs; sometimes, prices can drop by over 30% in just one year.

2. Types of Risk

• Systematic Risk: This is a risk that affects the whole market or economy and can’t really be avoided. For instance, when the economy goes into a recession, most stocks tend to lose value.
• Unsystematic Risk: This risk is specific to a single company or industry. For example, if a company is involved in a lawsuit, its stock price might drop a lot. This only affects that company and its investors.

3. Measuring Risk

• Standard Deviation is one way to measure how much investment returns can change. A higher standard deviation means there is more risk. For instance, if a stock has a standard deviation of 15%, it is riskier than a bond with a standard deviation of 5%.
• The Sharpe Ratio helps investors understand how much return they are getting for each unit of risk they take. It’s calculated like this:

$$\text{Sharpe Ratio} = \frac{\text{Expected Return} - \text{Risk-Free Rate}}{\text{Standard Deviation}}$$

This ratio is important because it shows how well the return of an investment compensates for the risk involved.

4. Making Investment Decisions

• Knowing how risk plays a role is crucial for managing investments wisely. One excellent strategy is diversification, which means spreading your investments across different types of assets. For example, a mix of stocks, bonds, and real estate can help make returns more stable.

5. Real-Life Examples

• Students should understand how big economic factors, like interest rates and inflation, affect systematic risk. For instance, if interest rates rise by 1%, bond prices might drop by 10%. This shows why it’s important to think about risk when making investment plans.

By learning about these concepts, finance students can make smarter decisions and build better investment portfolios while reducing the chances of losing money.