What is “Risk and Return”?
The relationship between risk and return is a fundamental investment concept. The concept states that an increased probability for return is highly correlated with the increase in the level of risk taken. The return is expressed as a percentage and refers to the gains or losses made from an investment, whereas the risk element is associated with the volatility of that return. In theory, an investor could expect higher return on investment only if willing to accept a higher level of risk.
Key Learning Points
- The optimal risk-reward profile depends on factors such as attitude towards risk, the ability to replace losses, and time horizon
- The risk-return tradeoff is assessed both on a single security and broader portfolio level during the investment decision making process
- Diversification is an investment technique and reduces risk and potential gains
- Concentration increases the overall risk and may offer a higher return
- Risk-averse investors normally prefer investments that offer lower but more predictable return such as bonds
- Those with a higher risk appetite tend to favor higher-risk instruments that offer more upside potential such as equities
The Risk-Return Tradeoff
The risk-return tradeoff is an investment philosophy in which high risk is correlated to high reward. There are a number of specific characteristics considered when defining the optimal risk-reward tradeoff including: investor’s risk appetite, time horizon and ability to generate funds that offset losses. For example, a long-term investment in a riskier asset such as equities may provide the opportunity to participate in rising markets. In theory, the longer time horizon will likely offset losses incurred during any market decline. The same investment over a short-term period would bear a higher risk as the shorter time period may not be long enough to allow for a stock to recover from any short-term losses. This tradeoff concept is essential for both decision making and ongoing monitoring and assessment of existing portfolios. This could also include assessment of portfolio diversification or concentration of holdings.
Diversification is a risk-management technique that aims to limit specific risks in a portfolio and deliver a smoother investment journey. Its philosophy is to invest in a broader range of securities that show less correlation so that if there is a downturn, it might not negatively impact all the holdings in the portfolio to the same degree. As a result, a portfolio would be exposed to a lower level of risk. On the other hand, if a portfolio holds a lower number of securities and/or is overweight in a specific area of the market, this would increase the level of risk, but may also offer greater upside potential. This ‘concentration’ is another example of the relationship between risk and return.
Risk and Asset Classes
While risk cannot be completely eliminated, it can be managed by holding a diversified portfolio of varying, low correlated asset classes. Investors should be aware that the right mix in the portfolio depends on the individual’s risk tolerance level as well as end-goals from the investment. The lower risk assets that usually offer lower but more predictable rate of return include: money market instruments and fixed income securities. On the other hand, equities, commodities, and derivative securities are considered a higher risk and can offer the potential for higher returns.