The Risk-Return Principle

Investment theory suggests that the risk associated with an investment is closely related to its return. But we don’t need investment theory to tell us that. This is embedded in everyone’s minds. How much you are willing to risk depends on how much you can potentially gain. It follows that the higher an investment’s risk is, the higher the return you should demand.

High Risk Vs Low Risk

Words such as risk and uncertainty can often scare investors and stop them from investing in high-risk assets. It is important to note that low-risk investments such as Government Bonds do exist. However, they alone are often unable to provide us with sufficient returns to reach our long-term financial goals. In many cases, low-risk investments even struggle to hold up against inflation rates. As a result, investors can lose money over time which is not quite the idea behind long-term investing.

The link between risk and reward is academically known as the Risk-Return Principle. There will always be a trade-off between low-risk and high-risk investments. The more uncertainty an investment bears, the higher the possible return can be. At the same time, with more uncertainty comes higher risk and your investment has a higher probability of failing or having a lower than expected return. A combination of low-risk and high-risk investments can bring the best of both worlds and, in most cases, is best suited for the majority of investors.

Risk Appetite Vs Risk Tolerance

The theory behind the correlation of risk and return can clear up the investor’s mind to a large extent. But if you wish to look deeper into it, there is more. So, before you decide to hide your money under the mattress, let’s answer some of the most common questions associated with risk and how it can be managed:

  • How much should you invest?
  • Where should you invest?
  • Should you invest in low-risk assets, or should you go for high-risk assets?
  • How much risk is too much?

The above questions can be answered based on the Risk-Return Principle and, more specifically, your risk appetite and tolerance. Risk appetite is the amount of risk you are willing to accept or assume to achieve your objectives. Risk tolerance is the amount of risk you can handle, based on factors such as age, years left until retirement, income and accumulated wealth. To understand these concepts better, let us use Jennie and George as examples:

Jennie is 27 years old, earns a healthy salary and currently wants to start investing for her retirement. However, Jennie is unfamiliar with riskier, high-return assets such as Public Equities and Alternative Investments. As she is lacking knowledge of these types of securities, she is intimidated by them. Therefore, Jennie chooses to invest solely in Government Bonds due to their low-risk nature. In this case, there is a mismatch between Jennie’s risk appetite and risk tolerance. Her risk tolerance is relatively high, as she is still very young, has a lot of years until retirement, and earns a high, stable income. However, her risk appetite is low, mainly due to her lack of knowledge of these higher-risk investments. Although a low-risk portfolio can be sufficient to maintain her real wealth by protecting against inflation, it will not be enough to grow her wealth. Therefore, Jennie can significantly benefit by learning more about the higher-risk asset classes and combining these with the lower-risk investments to create a well-diversified, balanced portfolio. This will allow her to grow her wealth over time and save enough money to enjoy a more comfortable retirement.

On the other hand, George is 57 years old, and he wants to start contributing to his retirement. George makes less money than Jennie, but he is familiar with different asset classes. He wants to start investing a big part of his wealth aggressively into Public Equities and other Alternative Investments. Although George understands these different asset classes, he is not interested in lower-risk Government Bonds. He wants to make as much money as possible before he retires eight years from now.

Similarly to Jennie, we can observe a mismatch between George’s risk appetite and risk tolerance. George’s risk appetite is high, as he wants to invest only in the higher-risk asset classes and make high returns quickly. Conversely, his risk tolerance is relatively low, as he is much older than Jennie, has fewer years to retirement, and has a lower income. Thus, by going ahead with his plan, George can potentially achieve his goals. Still, there is also a high probability he does not. These higher-risk asset classes cannot guarantee high returns in the short and medium term or even in the long term. Therefore George can potentially lose a high proportion of his invested wealth by the time he retires. Consequently, as was the case with Jennie, George will benefit by combining the higher-risk investments with lower-risk investments in his portfolio to create a balanced portfolio suitable for his objectives.

Takeaways

We can learn from these two examples that no matter what your risk tolerance or risk appetite is, you will always benefit from a well-diversified portfolio. This is because the risk tolerance and appetite aspects come into play when deciding the exact allocations of the different asset classes in your portfolio. If you want higher returns, you can increase the portion of equities and alternative investments. If you want to play it safe, you can increase the allocation of government and corporate bonds, real estate and commodities.

Investors need to understand that they should not let the fear of risk inhibit their ability to make investment decisions. Instead, they should use an appropriate level of risk tailored to their needs to realize the returns suitable for them over the long term.