When it comes to investing, what is the relationship between return and risk in investing? Why are the two related? By understanding the relationship between return and risk in investing, this will make it easier for you to make investment decisions.
We already know that there are several asset classes such as gold, bonds and equities. When we own these assets, it is important to understand how to differentiate them in terms of return and risk. Because it will make it easier for you to adjust the target and investment process.
Economists are accustomed to saying that there is no such thing as a “free meal”. In other words, any high return on an investment comes with significant risk, and any safe investment comes with low return. This is called the risk-return ratio.
Return and Risk: What’s the Relationship?
When you are diversifying your portfolio, you are also combining several investment instruments to achieve your target. So, is the investment mix right for you? Usually, the two most influential factors are return and risk.
Return or yield, is the expectation of the money generated from your investment. While risk is the possibility that will occur when the actual return is different than expected, and so is the amount. In other words, risk is the amount of volatility associated with an investment.
Four Types of Main Asset Classes
- Equity: A type of investment that is ownership in a company, or it can also be called shares.
- Bonds: Investments like debt. For example, you buy a bond, meaning that you give a loan to a company (or government) and you will get a return in the form of interest. As well as the initial capital that will be returned at the end of the specified time.
- Alternative Investments: This category includes investment in property, commodities, gold. Sometimes, this asset class carries a higher risk than equities and bonds. However, expected returns have different patterns and trends than equities and bonds. So, this asset class is suitable for diversification.
- Cash: That’s right, cash. But in an asset class, cash is also a liquid, short-term investment. For example, short-term deposits in banks, because access is easy.
Why this risk-return pair?
Because investors are only willing to take more risk in exchange for a higher expected return. Symmetrically, an investor wishing to improve the profitability of his portfolio must accept to take more risks.
Each investor is more or less “risk-phobic”, he has his own appreciation of the “optimal” risk / return balance .
The risk behavior also depends on the amount to be saved. If the amount of savings is large, the investor may devote part of the total amount to risky investments. On the other hand, if the level of savings is low, investments with low yield but safe are preferred.
On the financial markets, the least risky assets are bonds issued by certain states deemed to be safe, such as the United States, Germany or France, to finance their public debt.
Volatility is an important part of assessing risk.
Volatility measures changes in the price of financial securities: stocks, currencies, bonds, etc. The more “volatile” a stock, the more sensitive its price will be to good and bad news about the company or the markets. High volatility means that the price fluctuates significantly and therefore the risk associated with the value is high. The volatility of stock prices is generally higher than that of bonds. But statistical studies also show that time reduces stock volatility. Therefore, long holding reduces the risk.
The risk premium
It is the difference between the yield on a government bond and the yield on a riskier investment , such as a corporate bond or a stock. In other words, it is the additional remuneration that is offered to the investor so that he agrees to buy these bonds or these shares rather than subscribe to government bonds. Bond yields compare directly to government bond yields. It is always higher, because the risk of default by the borrower is greater.
If the investor wants to sell his bond before maturity, the price he will receive will be linked to the evolution of interest rates. If rates have gone up, its bond will lose value when it is sold before maturity, since it offers a lower yield than new bonds.
When it comes to equities, it is traditionally considered that they perform better over the long term than bonds because of the higher risk they represent.
The more difficult a company is, the greater the doubts about its ability to repay its loans (bonds) or to generate profits (shares), the lower the price of the bonds it issues and the lower the price of its shares. .
In fact, historical analysis of stock returns in the United States (and this analysis is more or less valid for other developed economies) shows a real, i.e. inflation-adjusted, annual return, including between 6.5% and 7%, which is much more than the yield on long-term government bonds (1.7%). The 4.9 point difference is the risk premium.
If we compare, as does this study, nearly two centuries (XIX th and XX th centuries), the annual return on stocks and bonds, there is a greater gap between the best and the worst stock performance that ‘between the best and the worst bond yields. This would confirm that equities are both more profitable and riskier than bonds.
The paradox of actions
Various studies have sought to prove that in the long run, stocks are not riskier than bonds, although they offer a much better return .
The principle is the following: the good years would compensate the bad ones. In the long run, stocks would not be riskier than bonds and might be suitable for even the most cautious investors. The better return on equities could still be explained by the risk of a total market collapse, except that… of all the catastrophes that were analyzed, bonds recorded lower profitability than equities.
So, in the long term, stocks are definitely not riskier despite having a better return… But it is still necessary to protect against poor short-term performance. The best way is to have a diversified portfolio . This will lower the level of risk and undoubtedly also the expected average return, but it makes it possible to be situated higher in terms of return while respecting its “level of risk aversion”.
The duration of the placement
Several studies (from INSEE) have shown that the probability of making a gain increases with the duration of the investment and that the extension of the investment period reduces the risks. loss, although this lengthening can also reduce the chances of a particularly high peak gain.
As robust as these findings may be, it should be emphasized that they were established on the basis of past statistics over the medium and long periods, which do not, in any case, allow us to assume future performance.
Ideal Investment Portfolio
An ideal portfolio will be arranged based on a balance between return and risk.
For example, suppose you are planning to buy a house within 3 years and maybe you also don’t want to put your money in risky assets. You want your savings to be available when you are ready to pay the down payment on the house.
So, you optimize security, as well as lower returns. Your portfolio may be allocated more towards bonds that are low in risk and cash, and only slightly on equity.
Meanwhile, if you invest in a goal in 10 years, you may not have a problem with the current risk, considering that your investment horizon is still long.
So, to maximize your returns, you might be going to allocate more equity to your portfolio, then bonds and a little cash.
The bottom line …
You need to understand returns and risks. As before buying any other item of great value, make sure you know the risks behind it.