Does Higher Risk Always Mean Higher Returns? Are Lower-Yielding Investments Safer?
When you invest money, you want to get the biggest return you can, right? But you don't want to take too many risks with your money either... You know what would be perfect... an investment that pays a huge return that is guaranteed to have no risks to your money. And I know exactly where you can find one... at the end of the rainbow guarded by a yeti riding a unicorn.
In the real world, everybody else also wants high returns and low risks. That means that you have to make a trade-off. If you want lower risks you have to expect lower returns, and if you want to try for higher returns you have to accept more risk to your money.
This is such a general principle of investing that it is worth saying again:
Higher expected returns (generally) mean more risk to your money and vice versa.
(Note: This isn't always true. Sometimes you can rejig your investment portfolio to make sure it is getting the most it can for the risks you take (like diversifying the assets you hold) but once you have made your portfolio efficient, the only way to increase returns is to increase risks.)
Remember that investing is always an uncertain business. You don't know whether a company you invest in will go bust next month, even if you have done your research. You don't know how interest rates on savings accounts will change in the future.
Sensible investing is all about managing this uncertainty and the risks it brings. That means that sensible investors will demand a higher expected return if they think an investment is risky (and by risky we usually mean there is a chance you won't get your money back).
Remember that taking more risks doesn't guarantee a better return (that is why it is a risk!)
Example: Index-Linked Bonds
For example, index-linked bonds (which offer some protection against inflation by increasing in line with an inflation index) have lower expected returns than the same conventional bonds where the coupon payments are fixed, even when you take away expected inflation. This extra difference is sometimes called the "inflation risk premium". It's the price some investors are willing to pay to reduce their "inflation risk".
Risk and Return for Different Types of Investment
There are plenty of different types of investment out there (sometimes called different asset classes). Each one has different trade-offs between the risk you take and the return you make.
Some investments are relatively low risk and low return like investing in Government bonds of developed countries (e.g. UK Gilts). Or blue chip shares.
Your Risks Vs Market Risks
That risk (that the investment won't pay what you expect, and may even not give you your money back) is called a market risk. That risk is the same for every investor, so it is reflected in the returns you expect to get on the investment.
But there are also your personal risks—these depend on what you need the money for. For example, if you are saving up to buy a house, then you care more about how the investment does relative to the price of houses than how it does overall. There is no use in getting a 10% return if house prices have gone up 20%. Or if you are saving up for your old age, you care more about the returns on your savings relative to the cost of living in retirement.
These risks are not usually reflected in the market because not everyone has the same risks. That means you should think carefully about what you are investing for and may want to take individually tailored financial advice about how best to manage your personal risks.
"Risk appetite" means how much investment market risk you are willing and able to take.
If you need to have your money available for a rainy day you don't want investments that take a long time to cash in or whose value fluctuates a lot (because you might have to sell it when it is not worth very much). In other words you have a small appetite for risk.
On the other hand if you have lots of other savings and don't need to cash in the investments at a particular time then you can take a risk on more uncertain investments in the hope of a big payoff. You have a big appetite for risk.
When investing you should think about your risk appetite. If you have an adviser they will try to find out exactly what your risk appetite is so that they can advise you on the products that might suit you.
Generally speaking the more risk you are willing to take with your money the bigger return you should expect to make. But remember nothing is guaranteed. And invest wisely to make sure you are rewarded with better returns for any risk you do take.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
© 2013 Cruncher