When you are investment, what is the relation between risk and return in making investments? Why are the two connected? If you understand the relation between risk and return when investing, this can aid investors to make better investment decisions.
We know that there are a variety of types of assets like bonds, gold, and equity. If you own these types of items, it is crucial to be aware of how to differentiate between them in terms of returns and risk. This can make it easier to alter your target and investment strategy.
The economists have a tendency to say that there’s no such thing as”free food” or a “free meal”. That is to say that any high yield on investment is accompanied by high risk. Likewise, every safe investment has the possibility of a low return. This is known as”risk return ratio.
Return and Risk: What’s the Relationship?
If you’re diversifying your portfolio, you’re also combining various investment options to reach your goal. What is the best combination of investments right for you? Most of the time, the two factors most important to consider are the return as well as risk.
The term “return” or yield refers to the anticipated value of the money that is generated by your investment. The risk is the probability that the actual yield is lower from what you expected, as is the quantity. Also risk is the degree of risk associated in an investment.
Four Types of Main Asset Classes
- Equity: An investment that consists of ownership in the company. It could also be referred to as shares.
- Bonds: Investments like debt. In the case of a bond, for example, you purchase bonds, which is to say you loan money to a business (or an agency of the state) and you’ll receive an amount in the kind of interest. Along with the initial capital which will be returned at the conclusion of the time period you have specified.
- Alternative investments: This class comprises investments in commodities, properties and gold. In some cases, this class of asset is more risky than bonds and equity. However, the expected returns exhibit distinct patterns and patterns than bonds and equity. Therefore, this asset class can be used to diversify your portfolio.
- Cash: That’s right, cash. However, in the asset class, cash can also be an investment that is liquid and short-term. For instance, you can find short-term deposits at banks are a good option, as they are easy to access.
What’s the significance of this pair of risk-return?
Since investors are only willing to risk more to get a better anticipated return. In a similar way, an investor who wants to increase the profit of his portfolio has to be willing the possibility of taking on more risk.
Every investor is either “risk-phobic”, he has his own view of what is the “optimal” risk / return balance .
The risk-taking behavior of the investor is also dependent on the amount saved. If the savings amount is significant, the person saving could allocate a portion of it to investments that are risky. However when the amount of savings is small the investments that have a low yield but are safe are the best choice.
On the financial market the assets with the lowest risk are the bonds issued by specific states considered to be safe, like Germany, the United States, Germany or France to fund their debts to the public.
The ability to predict volatility is an essential aspect of the assessment of risk.
Volatility is the term used to describe changes in the prices of financial securities, such as bonds, currencies, stocks and so on. More “volatile” a stock, the more dependent its price is to positive and bad news regarding the company or markets. A stock with high volatility means that its price fluctuates dramatically and the risk of the price is very high. The volatility of prices for stocks is usually greater than bonds. However, studies have shown that the passage of time decreases volatility of stocks. So, long-term holding decreases the risk.
The risk-based premium
It’s the difference in the yield of a government bond and the yield of an investment that is more risky like corporate bonds or stock. This is the additional compensation that is paid to the investor to ensure that they will purchase these shares or bonds rather than committing to the government bond. Bond yields are directly compared with the yields of government bonds. It’s always higher due to the risk of default of the borrower is more likely.
If the buyer wants to sell the bond prior to it is due, the amount the buyer will pay will be determined by the changes in interest rates. If rates have increased it will be lost value when taken off the market before its maturity date, as it has a lower yield than the new bonds.
In the case of equities generally, they are believed that they will perform better in the long run than bonds due to the greater risk they carry.
The more complicated a business is, the more doubts regarding its capacity to pay its debts (bonds) or generate profits (shares) The lower the cost of bonds issued by it and the less expensive the cost for its stock. .
In actual fact, the studies of historical stock returns from the United States (and this analysis is generally valid for other economies with developed economies) gives a realistic, i.e. inflation-adjusted, annual yield, which ranges between 6.5 percent and 7percent and is significantly higher than the yield of long-term bonds issued by the government (1.7 percent). The 4.9 point difference in the yield is the risk cost.
If we look at with this study almost two millennia (XIX th and XX the centuries) and the annual returns on bonds and stocks and bonds, we find a bigger gap between the top and worst performance of stock than between the highest and lowest bond yields. This suggests that equity investments are much more lucrative and less risky than bonds.
The paradox of our actions
Many studies have tried to establish that, in the long run stocks aren’t more risky than bonds, even though they provide a higher return .
The premise is this The good years will make up for the poor ones. In the end stocks are not more risky than bonds and could be suitable for the most prudent investors. The greater return on equity can still be explained by the possibility of a complete market crash but… from the many catastrophes examined, bonds showed less profit than equity.
Therefore, in the long run stocks are not more risky, despite having higher returns… However, it is important to safeguard against short-term losses.
The best approach is to create a diverse
. This reduces the amount of risk and , most likely, the expected average return however, it allows it to be placed above the return, while still maintaining the “level of risk aversion”.
The time period of the placement
Numerous research studies (from INSEE) have proven that the likelihood of gaining a profit increases depending on the length of the investment. Furthermore, the prolongation of the period of investment decreases the risk. The loss is less, but this extended period may also lower the likelihood of a particularly high-pitch gains.
While these results may be, it needs to be noted that they were derived by analyzing past figures over medium and long time frames and don’t, at any time, allow us to predict the future results.
Ideal Investment Portfolio
A good portfolio should be constructed based on a balance between risk and return.
As an example, let’s say you’re planning to purchase an investment property within three years. You do not want to put your money into risky investments. You would like your savings to be accessible when you’re in a position to make the down-payment on the home.
Thus, you maximize security as well as lower returns. Your portfolio could be geared more to bonds that are lower in risk and cash, but only a tiny amount of equity.
In the meantime, if you make an investment in 10 years’ time, you may not be a concern in the present risk given that the investment horizon is still very long.
To increase your return you may decide invest more equity into your portfolio, and then bond and even a bit of cash.
The final word …
It is important to be aware of returns and risk. Before purchasing any other thing of value, you should understand the risks associated with it.