The most important Truth in investing: Risk and Return are always correlated
Everyone is looking for a strong return from their investments. That’s why we invest.

But beware of being seduced by reports of people making big money from investing. What the reports usually don’t say is that every great return comes with a corresponding great risk. In fact, when it comes to investing the two go hand in hand.

Most people are familiar with the general concept that risk and return are correlated, even though they might not understand that, in financial markets, the term ‘risk’ has a much more specific definition than in daily life.

Yes, it may be risky to walk to the edge of the cliff to get a great selfie, and it’s extremely risky to travel to a war zone for your holidays. However, that sort of risk is – at least to some degree – in the eye of the beholder.

In financial markets, the concept of ‘risk’ is not simply perceived, and therefore viewed differently by different people, but actual and measurable. When evaluating potential returns the corresponding risk is given a value, or at least a range, which allows us to compare the risk associated with one type of investment with that of another.

Quantifying the risk-return relationship

The accepted rules of the game always apply: the more risk you’re willing to take the bigger your potential return will be (and vice versa). Note that important word potential. We use that because almost nothing is certain in the investment world – apart from the fact that risk and return always go hand in hand!

The chart below shows the risk/return relationship of some common investments. There’s no scale shown on this chart because the actual numbers can change over time; its purpose is to show the relativities between various investments.

Risk - return graph

The dark line shows what is called the ‘expected return’ of these investments. This is the long-term average annual return. Cash - for example putting your money in a bank account or short-duration term deposit - has the lowest return and, as we move up the scale, we have Government Bonds, then REITs (listed real estate investment trusts, which offer a stable, bond-like income from dividends and invest in a diverse range of property including city buildings, office parks, land banks and shopping malls).

Australian Shares are next in line, then Global Shares (where we may have some additional currency exposures) and then Unlisted Shares. At the same time, some equities are riskier than others. For instance, unlisted shares in a new technology venture are much riskier than listed shares in a gas pipeline company that transports gas under a long-term supply contract.

We know from real-world experience that there’s a range of actual outcomes which lie on both sides of this average return. Some years do better than the average, some years worse.

The wider the range, the higher the risk

Also shown on this chart is the risk of these investments. When finance people talk about risk they’re referring to the width of the range (or the Standard Deviation) of outcomes around the average. The wider the range, the higher the risk. The dashed lines on the chart show how risk increases as expected return increases: the range of outcomes for cash and bond investments is narrower than for REITs and equities, which shows the increasing risk relationship of these asset classes.

Return and risk are inseparable. In the finance markets these concepts are always spoken about together. They are two sides of the same coin. The implication for investors is that you can’t have a higher return without taking on higher risk. Take a look at the returns on some Australian investments between 2000 and 2017:

 

Worst

Average

Best

Cash

1.70%

4.50%

7.60%

Bonds

1.70%

6.10%

14.90%

A-REITs

-54.00%

7.40%

34.00%

Shares

-40.40%

8.20%

39.60%

Australian Asset Class Returns 2000 - 2017

The wide range of results in Equities and A-REITs contrasts starkly with the results for the more conservative investments Bonds and Cash.

This is a good demonstration of the link between return and risk, one of the immutable laws of investing. You can see that the average returns of each asset class rise, but the most striking feature of these statistics is how widely these best and worst returns are spread from the Average as the expected return increases.

This is the two-edged sword of investing: while the average return increases so does the dispersion of the best and worst returns from that average, which is the risk. To a professional investor, risk is measured using the average return and a measure of how widely the best and worst returns are dispersed from that average.

If you understand the risk, you can accept it (or not)

Investing in higher-return assets means you’re accepting the higher risk that goes along with them. One way of looking at the potential for a higher return is that it is ‘compensation’ for bearing the extra risk.

You could put your money in long-term government bonds, accept your regular interest payments and be very certain that your principal would be repaid on maturity. For that you’ll get a lower return than if you accepted the higher volatility of returns and the higher risk of losing some or all of your principal from investing in equities.  It’s plain to see that without taking more risk you can’t have more return.

That’s why it’s misleading to hear from someone who has a fantastic tale to tell of the brilliant returns they’ve made from an investment without also hearing them talk about the risk they took on. Hearing about the returns on their own is only half of the story.

To use an example, someone who was lucky enough to invest in Facebook shares in 2005 has undoubtedly made a fortune, but by investing in a speculative, unlisted technology company they also took on a huge amount of risk. If they’d invested in any number of other start-ups (which they may have – they won’t tell you that!) trying to do something similar, they’d have lost their money.

Another more extreme example: if you walk into a casino and put $10,000 on red at the roulette table, and red comes up, you may have just doubled your money, but no-one would pretend you’re a good gambler who has any great insight. You’ve just been lucky.

You have to choose your risk comfort level

Choosing investments is a little like choosing which car you’ll drive: do you want slow and steady or fast and furious? What return do you really want, and do you find the corresponding risk within your own acceptable range? Just remember that your potential return depends entirely on how much risk you’re prepared to take.

The risk/return trade-off is yours to choose and there are countless ways to mix the assets that you select for your portfolio. What matters is properly understanding the risk/return trade-off before you invest.

Most importantly, you must understand that if you aim for high returns, you are, by definition, accepting high risk, and that if you can only handle very low risk in your portfolio, you will never achieve high returns.

There is no objectively right or wrong approach; it all depends on you and your circumstances.

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About the author:

Angus McLeod is a 25-year veteran of the financial markets, having spent 12 years as an equity portfolio manager. He holds a degree in Economics, a master’s in Applied Finance, and is a CFA charter holder and a CIMA® certificant. Angus is a lecturer in the Master of Finance course at RMIT University.

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