Correlation Between Risk and Return on Investment
Return on investment is closely connected with the notions of equilibrium and uncertainty. The investment rate should be analyzed both in the short-term and in the long-term run since the dynamics in different time periods are different. Thus, this paper aims to explain why in the long run, the rate of return on investments reflects the riskiness of the investments. The return of investment seems to depend largely on the longevity of the period analyzed and on the wide range of risks that should be considered.
The investment rate is closely related to the mechanism of equilibrium. As Froeb et al. (2018) put it, “in equilibrium, differences in the rate of return reflect differences in the riskiness of an investment” (p. 117). It can be explained in the following way: shortly after entering the market, firms can gain high profits. However, in the long run, their profits tend to reach an average level. For hypothetic firms in the conditions of maximum competition, the economic profit, in the long run, would reach zero. This situation is reflected in the investments since the investment rate tends to revert to the mean level.
The long-run analysis reveals that after the equilibrium, a risky investment becomes just as attractive as a less risky investment. In the beginning, before the equilibrium, the investors would move their capital from the riskier investment to the less risky investment if their return is the same. Thus, the price of the less risky investment is bid up. However, the higher price for the risky investment is associated with a higher return investment, which makes the two investments equal in the long run. The investors are compensated for bearing risk in the long run. This compensation for the risky investment is called a risk premium.
Short-Term and Long-Term Analysis
The analysis of the mechanism of short-term and long-term market returns can be found in the works of different researchers. For example, Harmancioglu et al. (2018) have analyzed it applied to the international co-development alliances. The research revealed that the investors prefer analyzing not only the short-term period of market development but to make a longitudinal analysis as well. This analysis based on a data set of 270 co-development alliances revealed that investors reward the firms in the short period and “punish them in the long term” (Harmancoglu et al., 2018, p. 939). Exchange conditions have some positive effects, but, nevertheless, these effects decrease over time. However, the positive news from the firm can draw new investments, and the decrease slows. Besides, in the long-term period, investors seem to perceive exchange rate conditions as transaction hazards. As for sharing innovation resources, they view it as a competitive advantage only in the short term. Thus, the risks influence the investment rate in the short term and in the long-term periods in a different way.
Types of Risk
Risks that influence the investment rate have different sources and should be analyzed separately. For example, they can be financial, which, in their turn, include interest rate risk, equity risk, and currency risk. There are also such types of risks as liquidity and concentration risks. Inflation risk, credit risk, reinvestment risk, horizon risk, and longevity risk also should be considered (Harmancoglu et al.,2018). Besides, apart from financial risks, there are political risks that influence the situation in the market. According to Balan (2019), foreign investors prefer not to invest in countries with high financial and political instability. However, foreign direct investment can promote products in the country and thus increase its growth rate. Thus, in the short-term political risk affects the investment prospects of different countries negatively, but in the long-term period, the investment can attract capital to the country and increase the investment rate. In general, the risks depend on the longevity of the period analyzed and different risks that should be considered during investment.
Balan, F. (2019). The effects of political and financial risks on foreign direct investments to the MENAT countries. Theoretical & Applied Economics, 2(2), 121–138.
Harmancioglu, N., Griffith, D. A., & Yilmaz, T. (2019). Short- and long-term market returns of international codevelopment alliances of new products. Journal of the Academy of Marketing Science, 47(5), 939.
Froeb, L. M., McCann, B. T., Shor, M., & Ward, M. R. (2018). Managerial economics – a problem-solving approach (5th ed.). Boston, MA: Cengage Learning.