the relationship between risk and return

What is the Relationship Between Risk and Return?

This is a guest post by Tomas Gutauskas at Dollar Break, a blog on a mission to help you master your money by providing financial tips, tools, and resources.

 

The primary aim of investments is to ensure that your money grows as much as possible. Whether you’re saving for a specific goal such as a down payment on a new home or you’re planning for your retirement, investments have the potential to help you to reach your financial goals more quickly compared to simply saving money.

However, every type of investment carries some degree of risk, so you need to carefully consider your investment strategies and appreciate the relationship between risk and return.

 

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The Basic Principles of Risk

Before you can start to discover the least risky investments, you need to appreciate the basic principles of risk and the relationship between risk and return.

Risk simply refers to the potential loss associated with investment decisions. The concept of “guaranteed” investments is a myth, and all investments carry at least some risk.

 

The Different Types of Risk

To understand the relationship between risk and return, you need to know that there are different types of financial risk. The most notable include:

  • Liquidity: In order to cash out of any investment, you will need to find someone willing to purchase it; if you’re unable to find a buyer, your investment capital is trapped. Therefore, there is a risk if you need to access the value of your investment and cannot find a buyer; you may even need to lower your selling price to make it more appealing to potential buyers.
  • Inflation: Even the “safest” investments still carry some risk, but this is usually limited to inflation risk. For example, if you put money into a savings account, although your capital is protected if the rate of inflation is greater than the interest you accrue on the account, you will have less buying power. All investments carry inflation risk, so you need to have an awareness of the impact the overall economy can have on your investments.
  • Business: There is also a risk that the company you’re investing in may cease trading and go out of business. In this type of scenario, you could lose some or all your investment capital. Older companies with a track record of performance are viewed as carrying a lower risk compared to less well established enterprises or start ups.
  • Volatility: Finally, you need to consider volatility risk, which is a measurement of how the investment fluctuates in value. If an investment has greater volatility, it is viewed as riskier compared to a more stable investment. This is due to the fact that there is a risk that you may be forced to sell if the investment value is lower when you need to release your capital.

 

The Risk and Return Relationship

Investopedia confirms that there is a positive correlation existing between risk and return; higher risk creates a greater potential for profit or loss. While this may seem tricky for a new investor to understand, it is possible to break it down into simple terms.

Imagine a scenario where you have a choice between two companies; Alpha has been in business for almost a year and to date has not reported a profit, whereas Bravo has been established for over 40 years and has a proven track record of profit and stability. Your financial advisor says there is a 50 percent risk of losing your money with Alpha, while Bravo carries just a 5 percent risk. If both these companies are offering the same return on investment, choosing Bravo is a no-brainer as there is no incentive to take on the riskier Alpha.

However, if Alpha offers a potential return of 25 percent and Bravo is only offering 3 percent, there is a greater potential for return that may tempt you to invest with the additional risk.

 

Managing Your Investment Risk

Fortunately, there are a number of strategies and techniques to manage investment risk.

Diversification is one of the most commonly used strategies, and this involves carrying different investment types within your portfolio. This allows you to still enjoy decent returns, but the overall risk is lowered.

The most common investment types for a diverse portfolio are:

  • CDs: CDs or Certificates of Deposits are available for up to a 60 month term, and according to FDIC data, they carry an insurance limit of up to $250,000 for an individual or for joint accounts $500,000. Although you are not likely to lose your investment capital, you still need to consider inflation risk and potential penalties should you want to cash out early. CDs are considered to be the lowest risk investment type, and most banks and credit unions can offer this investment group.
  • Stocks: These are shares in a company with a value depending on several factors, including the financial health of the company. Stocks are considered riskier for short term investments, as there is a fluctuating value, but long term investments show significant increases. In fact, according to National Bureau of Economic Research data, 50 percent of Americans now own stocks.
  • Bonds: This is, in essence, a loan that is made to the government or a company in return for an interest payment. The rate is determined by the reputation of who is issuing the bond; a company with a good credit rating is not likely to default on its debts, so there is less risk and usually lower interest rates.

 

Evaluating Your Risk Profile

There isn’t a one size fits all answer to how much risk you are willing to accept in your investment portfolio; it depends on different factors. There are three main areas that need to be considered to determine if a specific investment is the right choice for you.

The first thing to consider are your financial goals. You will need to consider how much risk you’re willing to accept in order to reach your goals. Typically, the more time and more money to invest, the less risk you’ll need to reach your goals.

Your investment timeline is also a factor; if you have a longer timeline, you should be able to ride out any volatility in the short term to recover any potential losses. However, if you’re working on a short timeline, you will be required to assume less risk, as you will have less time to recoup lost value.

Finally, you need to consider your personal risk tolerance. This term is used to refer to the amount of risk that you’re willing to take. As a new investor, you’re likely to have a lower risk tolerance, but your risk tolerance is likely to grow as you gain more confidence and experience.

 

So, How Do You Manage the Relationship Between Risk and Return?

As we’ve discussed, all investments carry some risk, but it is very risky to focus on just one investment. The most effective way to protect yourself is to use diversification. There are different models to employ diversification, but it can be done just by splitting your investment money between several different assets.

You should not only have investments in different asset classes, but it is also a good idea to diversify within the classes. So, rather than have all your money in one type of stocks, have multiple stocks, CDs, and bonds.

A new investor may also find that the easiest way to ensure a diversified portfolio is to invest in an EFT or exchange traded fund. This is a low cost investment option that often includes several stocks, bonds, and commodities, allowing investors to enjoy diversification almost instantly. This will allow you to manage your risk while enjoying a decent return, so you can work towards reaching your financial goals.

 

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