The relationship between risk and return is fundamental to investing decisions. Every investment considers the interaction between the two ideas, so investors need to be able to appreciate how risk and return work together to understand the risk-return trade-off.
Return is the income received from an investment. Returns are almost certain in some form or another, whether this is positive or negative. However, returns deviate due to risk. Risk is the possibility that the actual returns on an investment won’t match that of the expected returns. Each investment is exposed to a number of risks, depending on the type of asset.
Risk works directly with returns. Every investment will have returns in some form, and every investment will have risk which affects them. When considering risk and return in your investment decisions, there is, on average, a trade-off between the two. It is important to find the right balance between your level of risk and the rewards you seek in order to try and achieve the most success when investing.
The trade-off between risk and return
The relationship between risk and returns considers the amount an investment returns compared to the amount of risk taken. Between these two ideas, there is said to be a positive relationship between risk and return, as shown in the following graph:
The Risk-Return Trade-off
As you can see, in its simplest form, the graph suggests that there is a positive correlation between risk and reward, and allows you to draw the conclusion: When the amount of risk increases, expected returns increase.
The risk-return trade-off suggests that the greater the risk taken by the investor, the more they can earn from their investment. Essentially, it indicates that high risk equals high rewards, whilst taking a low risk means you should expect returns to match. This idea works in theory. On average, riskier investments do generate greater returns.
However, the fact is there are no guarantees when investing. Risk does not equal returns. It is possible that you are able to benefit from higher returns from taking greater risks. However, it also means that these investments tend to have the highest chance of failing to meet the expected returns and could mean you are more likely to lose money.
In short, the risk-return trade-off suggests the greater the risk:
- The greater the potential returns could be
- The greater the chance of losing some or all of your investment
The risk-reward trade-off gives you an idea of the type of investment decisions you can make. You can begin to decide on a level of return which is right for you and determine the risk you are willing to take on. Essentially, it can be used as a guide to help you choose what to invest in, whilst being realistic and rational in your decision making.
Choosing the ideal risk-return trade-off
As you will consider both risk and return when you invest, you will need to factor them into every decision. Every investment requires a consideration to the two and therefore the risk-return trade-off is a useful guide to choosing investments. The trade-off allows you to consider both risk and return and settle on a balance. Below are some ideas for putting together the right risk-return trade-off for you:
· There is no optimal level of risk and return
Unfortunately, when it comes to investing, there is no ideal risk-return trade-off. There is no place on the graph which can be described as better than any other. Whilst everyone wants those high returns, not everyone is willing to take that risk.
Whilst there is no perfect level, you can identify the ideal risk-return trade-off which is suitable for you. When you begin to consider your own trade-off, you need to contemplate the returns you want to make, and the risk you are willing to take on to achieve them.
· Expected return is not actual return
When it comes down to making your investment decisions, it is likely that you have an idea about the returns you wish to achieve. The returns you set out to reach should match your goals and help you to accomplish your ambitions from investing.
However, as noted above, there are no guarantees. There are all kinds of variations between expected and actual returns. This is because of the risk involved. Whilst you can aim for a specific level of return, you will need to be able to take on a level of risk to match. Otherwise it isn’t the right trade-off for you. It means you will need to be more realistic about the returns you want and the decisions you make.
· Risk affects every investment
Understanding risk is perhaps most important factor in finding the right risk-return balance for you. Ultimately the level of risk you are willing to take on allows you to aim for appropriate returns relative to that risk.
Every investment will be impacted by risk. Therefore, you need to be able to choose a level of risk you are comfortable with. Also, it is key that you recognise the types of risk which could affect returns, the types of investments you could make and how you can begin to manage risk. Having an understanding of risk enables you to make rational decisions which match your personal attitude for risk.
· Choose the right balance of risk and return for you
The risk-return trade-off is all about the individual. Every investor is different and will therefore have their unique view of how they want to invest. Anything from the goals being set, investing time frame and personal financial situation could affect the way you choose your own risk-return trade-off.
When it comes to deciding how to balance risk and return in your decisions, you need to make sure it is worthwhile. Your investments should try to match your desired returns within a level of risk you are comfortable with. They need to fit into you and your personality, where finding the right balance can lead to success when investing.