5.4. Risk and Return Trade-Off: Unit 5: Basic Long-Term Financial Concepts

Unit 5: Basic Long-Term Financial Concepts
5.4. Risk and Return Trade-Off

Questions to Ponder
1. Are you a risk-taker? Why do you think so?
Answers may vary. It depends on the student’s perception. A possible answer could be: I
am a risk-taker because I am not afraid to try new things or sacrifice a little comfort in
exchange for considerable benefit.
2. Have you participated in a decision-making discussion? How does other people’s
opinion affect your decisions?
Answers may vary. It depends on the student’s experience. A possible answer could be:
Yes, I have participated in a discussion where decisions had to be made. I value my own
experiences and learnings, but the opinion of others also comes from their experiences,
and therefore, is valid. I try to listen to their opinions to determine the best course of
action.
3. Why is assessing your attitude in decision-making important?
Answers may vary. Assessing your decision-making improves your way of thinking and
making decisions. Your actions would affect your entire life or other people’s lives.
Check Your Progress

1. What factors determine the level of risk in an investment?
The certainty and volatility of money made or lost are the primary factors in determining
the level of risk of an investment.
2. How does an investor figure out how much risk he or she can take?
Answers may vary depending on the point of view. Usually, investors consider their net
worth in taking risks. Some investors rely on the time frame of the investment and how
long it would take to get the expected returns.
3. Suppose a client approached you and asked for your advice on investment options.
What questions will you ask the client and why?
Answers may vary. I will provide investment advice depending on the client’s time
horizon and bankroll. First, I will ask how much extra funds he or she has and when he
or she expects the money to be returned. Next, I will provide advice on whether a
high-risk or low-risk investment would be ideal for him or her.
5.4. Risk and Return Trade-Off 1

Try This
A. Identification. Identify the concept being described in each statement.
Risk 1. It refers to the uncertainty of gaining or losing funds from

investments.
Risk-Return Trade-Off_ 2. It is a relationship between the amount of risk an investor
takes and their expected return.
Return 3. It is defined as the money made or lost in an investment.
Risk Preference 4. It is known as the attitude of investors towards risks.
Risk Averse 5. An investor with this preference would take on minimal risk
if any at all.
B. True or False. Write true if the statement is correct. Otherwise, write false.
True 1. The concept of risk-return trade-off is the higher risk, the higher return will
be.
True 2. The time horizon suggests that the longer time you have in investment the
better.
False 3. Risks are only for wealthy businessmen.
True 4. Risk-return trade-off is also similar to “no pain, no gain.”
False 5. The investors will gain money even without taking risks.
Practice Your Skills

1. Mr. Cruz joined a reality TV contest where he could win ₱1M if he could guess the
correct box that contains the grand prize. The TV host offered ₱50,000 and let him
choose between the box with the unknown prize inside and the cash. He decided to
take the ₱50,000 money. Is Mr. Cruz risk-averse or risk-seeking? Explain your
answer.
Mr. Cruz is risk-averse. He has a chance to get a bigger prize but is afraid to take a risk.
He decided to take the cash rather than get anything if he chose the box.

2. Sheila is trying to save more from her income. She barely keeps her money because
of her impulsive expenses. Her friend suggested investing her money on stocks or
saving it in a bank account. She chose to invest in stocks. Is Sheila risk-averse or
risk-seeking? Explain your answer.
Sheila is a risk-seeker. Investing in stocks requires higher risk since fluctuation might
affect the return value. But stock investment may result in high profitability. So she
decided to invest in stock rather than in a bank account with low profitability.
3. Banks and financial institutions sold mortgage-backed securities extended to the
so-called NINJAs (no income, no job, and no assets). These are housing loans
granted to individuals despite not having a good credit history. Are these
mortgage-backed securities high-risk or low-risk investments? Explain your answer.
Investing in mortgage-backed securities from loans extended to NINJAs is considered a
high-risk investment. Since these debtors do not have sufficient assets or credit history,
the risk of default is high; raising the uncertainty of return.
4. Government agencies such as the Government Service Insurance System (GSIS),
Social Security System (SSS), and the Home Development Mutual Fund (Pag-IBIG),
offer bonds to investors. Are these types of securities considered high-risk or
low-risk investments? Explain your answer.
Government bonds are considered low-risk investments. The value of these investments
depends on the agency's performance but are nevertheless secured by the government.
Thus, returns are more certain compared to corporate bonds, which face the risk of
bankruptcy.
5. Assume you were presented with six different investment options. The
corresponding risks and return associated with each investment option is presented
in the figure below. Suppose you wanted to invest in low-risk securities. Which
low-risk investment is best to invest in? Explain your answer.
Investment A is the best investment option among all low-risk investments (A, B, C). It has
a slightly lower risk than Investment B but has significantly higher returns compared to B
and C.

Challenge Yourself
1. Assume that you are a financial advisor. Would you identify the client's time horizon
before giving him investment advice? Why?
Answers may vary. But as a financial advisor, it is important to determine the client's
time horizon before giving investing ideas. You must not jeopardize your client's money
by making sudden decisions.
2. Is being risk-averse a negative behavior when it comes to investment? Why do you
think so?
Answers may vary. Being risk-averse might miss great opportunities in earning more
money. However, if the person has a high-risk tolerance, he might be fond of gambling
and lose everything he or she has.
3. In the future, would you prefer to earn income from self-employment or from
compensation as a regular employee in an organization? Explain your answer using
the risk and return trade-off.
Answers may vary. It depends on the student's point of view and risk preference. A
possible answer could be: I prefer to earn compensation as part of an organization
because the salary is fixed and certain. Self-employment may yield higher income at
times but can also be volatile based on personal and industry factors.

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Unit 5: Basic Long-Term Financial Concepts

5.4. Risk and Return Trade-Off

Check Your Progress

5.4. Risk and Return Trade-Oﬀ 1

A. Identiﬁcation. Identify the concept being described in each statement.

Risk 1. It refers to the uncertainty of gaining or losing funds from

Practice Your Skills

5.4. Risk and Return Trade-Oﬀ 2

5.4. Risk and Return Trade-Oﬀ 3

5.4. Risk and Return Trade-Oﬀ 4

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