What is the Relationship Between Risk and Return?

The Risk Basics

Before you can explore the least risky investments, you need to understand the fundamentals of risk. In simple terms, risk refers to the potential for loss that is associated with your investment decision.

Since the concept of a “guaranteed” investment is a myth, all investments involve at least some degree of risk.

The Types of Risk

There are several types of financial risk, and the most important for investors include:

• Inflation Risk: Even the “safest” possible investments carry risk. For example, putting your money in a savings account will mean there is no risk of losing your capital, but if the inflation rate outpaces the interest you receive on the account, you will end up with less buying power. All investments carry inflation risk, and you need to be aware of how the overall economy will impact your investment.
• Business Risk: This is the risk that the company you invest in may go out of business. In this scenario, you may lose some or all of your investment. Less well established companies are viewed as carrying a greater risk as they lack the track record of an older company.
• Liquidity Risk: To cash out of your investment, you need to find someone willing to purchase it; if you cannot find a buyer, the value of your investment will be trapped. The risk is if you need to access your investment value and cannot find a buyer; you may need to make it more attractive to potential buyers by lowering your selling price.
• Volatility Risk: Almost every investment fluctuates in value, going up or down, and volatility is a measure of how often and by how much the value of an investment fluctuates. Greater volatility is seen as riskier compared to more stable investments. This is because when you need your money, there is a risk that you will be forced to sell when the investment value has dropped.

The Risk Return Relationship

According to Investopedia, there is a positive correlation that exists between return and risk; the higher the risk, the greater the potential for profit of or loss. Although this can be tricky for new investors to understand, it can be broken down into simple terms.

Imagine that you’re given a choice between two companies; Company A has been in business for a year and has yet to report a profit, while Company B has been trading for over 50 years and has proven profitable and stable in the long term.

Experts say that there is a 50 percent risk of losing your money with Company A, while Company B carries a 5 percent risk. If both companies offer the same return on investment, you’re likely to choose Company B as there is no incentive to choose the riskier company A.

However, if Company A carries a potential return of investment of 25 percent, while Company B only offers 2 percent, the potential for a greater return can tempt investors to take on the additional risk.

Managing Investment Risk

There are a number of strategies to manage investment risk. One of the most commonly employed strategies is diversification. This involves carrying different types of investment in your portfolio, so you can enjoy less overall risk while still enjoying decent returns.

The three most common types of investments to create a diverse portfolio include:

• Certificates of Deposit: This type of investment is available for terms up to 60 months and, according to the FDIC, carries an insurance limit of $250,000 for individuals and $500,000 for joint accounts. While you’re not likely to lose your principal investment, you still need to think about the inflation risk and the possible penalties if you need to cash out early. However, CDs are considered the lowest risk investment group and are available through most banks and credit unions.
• Bonds: This is essentially a loan made to a company or government in return for interest payments. The interest rate is determined by the reputation of the entity issuing the bond; companies with very good credit ratings are unlikely to not cover its debts, so there is less risk involved and usually a lower interest rate.
• Stocks: Stocks are shares in a company, and the value of these depends on the financial health of the company, but other factors are considered. Stocks are viewed as riskier in the short term, as the value can fluctuate, but in the long term, the stock market has risen significantly. In fact, according to the National Bureau of Economic Research, 50% of Americans now own some stock.

Determining Your Risk Profile

There is no simple answer to how much risk you’re willing to accept in your investments, as it depends on a number of factors. There are three primary areas where you will need to assess whether a specific investment is suitable for your circumstances.

Firstly, you need to consider your financial goals. You need to think about how much risk you are willing to accept to reach your goals. Generally, the more time and more money you have to invest, the less risk you will need to take on in order to reach your goals.

As we touched on above, your investment timeline is also an important consideration. If you have a longer timeline, you will be able to ride out any short term volatility and recover any lost value. However, if your timeline is short, you will need to assume less risk as there is less time to recoup any lost value.

Finally, you need to think about your risk tolerance. This refers to the amount of risk that you’re personally willing to take. New investors tend to have a lower risk tolerance, but as you gain more experience and confidence, your risk tolerance is likely to increase.

So, How Do You Come to Terms With the Relationship Between Risk and Return?

Any investment carries risk, but it is highly risky to put all of your money into just one investment. The best way to protect yourself is to employ diversification. While there are many models to diversify a portfolio, it can be done simply by splitting your money between different assets.

It is a good idea to not only split your money into the different asset classes but also diversify within each class. So, don’t just have all your money in one bond, but have different bonds, stocks, and CDs.

New investors also find one of the easiest ways to diversify is to invest in ETFs or exchange traded funds. These are low cost investment options that can include several bonds, commodities, and stocks and allow investors to enjoy almost instant diversification. This can allow you to manage your risk and enjoy a decent return that can help you towards achieving your financial goals.