Risk v Return
The relationship between risk and return (risk v return) is one of the most important foundational concepts of investing.
Understanding the relationship between risk and return will help you understand the advantages and disadvantages of the various investment options open to you, putting you in a strong position to make informed decisions on whether a certain investment or product is suitable for you.
Time Value of Money
To understand the risk v return tradeoff, it is first useful to understand the investment concept known as the time value of money. We can attempt to understand the time value of money by asking one simple question, that is, would you rather receive £100 now, or £100 in 10 years’ time?
The answer is clearly going to be £100 now, you’d rather receive that money now than in the future for a variety of reasons. Firstly, future cash flows are less certain, you don’t know when in the future you might receive or need that money. Having the money now gives you the flexibility to choose what to spend it on, you will have the opportunity to use that money as you wish.
Additionally, we can say that the £100 received now has more purchasing power than in 10 years’ time. What we mean by this, is that the price of goods and services increases over time. This is known as inflation. Just think of the price of a Cadbury’s freddo chocolate bar. These were significantly cheaper 10 years ago than they would cost to buy now.
As such, while the £100 you receive would still be £100 in 10 years’ time, it’s actual worth, in terms of what it can purchase will be less in 10 years’ time.
Putting this into the context of investing, because your money will be able to purchase less in the future, you expect to receive compensation in the form of investment returns for ‘locking it up’ in some form of investment.
We can therefore say there is a ‘risk’ that your money will be worth less in the future, as such, as an investor, you are going to want to be compensated for that risk.
We can also say you are going to want to be compensated for the risk that you do not receive some, or all of that money back.
This is the foundation of the risk v return relationship.
How Risk influences Returns
The greater the risk of you not receiving that money, or the value/purchasing power of that money reducing, the more you are going to expect to be compensated with greater investment returns.
This is a foundational concept for the world of finance and investing, it’s this same reason that people with a lower credit score are charged higher interest rates on loans and credit cards. The lender (the bank or credit card company) has a greater risk of someone with bad credit history not being able to pay the money they have borrowed back, as such, the lender charges them a higher interest rate to compensate for this risk.
Flipping this the other way, when you deposit money into a savings account with a bank, you will find that the bank will pay you a higher interest rate if you agree to keep that money there for an agreed period of time.
These accounts are known as fixed term deposit accounts. The reason these pay higher interest rates than savings accounts where you can access you money whenever you want (known as instant access saving accounts) is because you are locking your money away and as such are at risk of it being worth less/having less purchasing power in the future.
Equally, it is more valuable to the bank for them to have certainty about what deposits are available to them to then lend to other people, and as such, they will pay a higher interest rate for this comfort.
Risk v Return of different investments
We can apply these same principles to the various different investment options available to us, and this is exactly what investment advisors and wealth managers do with their clients. They will assess how much risk a client is able and wants to take on, and balance this with the returns the clients wishes to achieve to help select the investments that give the greatest returns for that level of risk.
We can understand the Risk v Return tradeoff with one simple statement.
The greater the risk, the greater the potential returns. The lower the risk, the lower the potential returns.
When looking at investment options, we generally consider the following main investment categories (known as asset classes) in risk order.
💷 Cash – cash deposits are perceived as being the lowest risk ‘investment’ this is because deposits in a bank are covered under the Financial Services Compensation Scheme for up to £85,000 per institution. This means that should the bank enter financial difficulties; your money is safe, and you will be able to recover it (up to the value of £85,000) no matter what happens.
This cover is set per institution, so if you have more than £85,000, it is best practice to split this across a number of different banks as you will then be covered for up to £85,000 at each bank you hold money with.
We can also take some comfort in the fact that historically, when banks have been in financial difficulties, the government has stepped in to protect the money of depositors.
Because of this security, the returns from deposits in savings accounts are generally quite low. However, if the money you have needs to be completely safe, such as savings for a house deposit, then this is likely to be the maximum level of risk you are willing to take on, and as such it is matched with an equivalent level of returns.
📜 Bonds – Bonds are considered as the next lowest risk investment after cash deposits. Because of the legal structure of bonds, there is a significantly lower risk of you losing all of your money like can happen with shares. It is important however, to note that this all depends on the issuer of the bond. Government bonds, particularly those issued by Governments like the USA and UK are often perceived to be ‘risk free’ because these Governments have historically, always paid their debts.
Bonds issued by less-creditworthy Governments, and bonds issued by corporations are riskier, but equally will have greater returns to compensate for this risk.
Because of the legal structure of a bond, the issuer (government or company) is legally obliged to pay your money back at the end of the bond’s life (known as maturity) and pay the agreed coupon (or interest) payments. For these reasons, bonds are considered less risky than shares. You should read Investing 101: What are Bonds to learn more about this.
🏭 Stocks & Shares – stocks and shares are considered more risk than Bonds and significantly riskier than cash deposits for the simple reason that there is a greater risk that you lose your money completely.
Unlike with a bond, where you are lending money to the company and they have a legal obligation to pay that money back, investing with shares does not come with this protection. This is because when you purchase a share, you now own a part of that company, rather than being a creditor to the company (someone lending the company money).
Shares are also considered to be higher risk because in addition to the possibility of losing your money, the investment returns in the form of income and capital growth are not guaranteed.
In terms of income, shares will usually pay a percentage of the companies’ profits to shareholders in the form of a dividend. This however will only happen if the company has made a profit, and even then, it is at the discretion of the company’s directors whether to make a payment or not. They could, for example, hold onto the money to invest in expanding the company.
In terms of capital growth, the price of a share can increase as a company grows, makes more money and/or becomes more profitable. However, the reverse of this is also true. The company’s shares can fall in price if the company has a tough year or is subject to a financial scandal or other adverse news. Just look at the fall in price of ted baker shares after a drop in sales was reported.
As such, there is a risk that your shares could be worth less when you come to sell them, and equally, in the event the company becomes insolvent and goes into liquidation, that they become worth nothing at all.
Because of all of this risk, the investment returns form shares are generally much higher than bonds and cash deposits.
The chart below shows this visually. We can see the tradeoff between risk and return (risk v return). If we want greater investment returns, we are required to take on more risk.
If however, we want lower risk, because perhaps we need to be guaranteed that the money we have will still be worth the same, or more in 1 years’ time, then we need to accept that we are going to receive lower returns in exchange for this comfort and certainty.
We won’t discuss property 🏠 in depth here, nor other asset classes (types of investment) which we could include on this chart, such as investments like hedge funds, and commodities like oil and gold. There placement is determined in the same way as the others, the risk of not getting your money back, and how long your money is locked up for, as well as how easy it is to sell your investment and turn it back into cash. We’ll keep it simple with just cash, bonds and shares for now.
How much risk should I take?
How much risk we should take on is a question only you can answer yourself, and we won’t cover it in depth here, but you should consider things such as;
- how you would feel if your investments were to decrease in value significantly?
- how long you plan to be invested for?
- how old you are?
- What sort of investor are you (income or capital growth)?
We generally say that investing over a longer time period allows us to take on more risk because we have time for the investments to recover and grow again if they drop in value.
With all that being said, most importantly, we also need to consider whether we are in a financially strong position to be able to invest in higher risk options.
If you have large amounts of debt that you need to pay, or the money you want to invest is needed for some financial obligation in the future, such as a house deposit, or repaying a student loan, then it is likely that you should be taking on the minimal amount of risk possible.
You should perhaps instead focus on budgeting, saving money and paying off your debt first, before looking at investing.
You should now have a good level of knowledge on the relationship between Risk and Return and be able to use this knowledge to drive your investing and money decisions.
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