In Chapter 2 we briefly introduced the concept of a market-imposed "trade-off" between risk and return for securities - that is, the higher the risk of a security, the higher the expected return that must be offered the investor. We made use of this concept in Chapter 3. There we viewed the value of a security as the present value of the cash-flow stream provided to the investor, discounted at a required rate of return appropriate for the risk involved. We have, however, purposely postponed until now a more detailed treatment of risk and return. We wanted you first to have an understanding of certain valuation fundamentals before tackling this more difficult topic.
Almost everyone recognizes that risk must be considered in determining value and making investment choices. In fact, valuation and an understanding of the trade-off between risk and return form the foundation for maximizing shareholder wealth. And yet, there is controversv over what risk is and how it should be measured.
In this chapter we will focus our discussion on risk and return for common stock for an individual investor. The results, however, can be extended to other assets and classes of investors. In fact, in later chapters we will take a close look at the firm as an investor in assets (projects) when we take up the topic of capital budgeting.