Understanding Risk vs. Return

One of the most basic concepts in investing is also one of the most important:

Risk and return generally go hand in hand.

Investments with very little risk typically offer lower potential returns, while investments with greater risk generally offer greater potential returns.

Of course, “greater potential return” does not mean “guaranteed higher return.”

An investment with significant risk may produce an excellent return, but it may also produce a mediocre return, no return, or even a significant loss.

Understanding this relationship is one of the first steps toward becoming a more informed investor.

What Is Risk?

In simple terms, investment risk is the possibility that your actual outcome will be worse than you expected.

That could mean losing some or all of your investment, but risk can take several different forms.

For example:

• Market risk: The investment loses value because the overall market declines.
• Business risk: A company performs poorly or fails.
• Credit risk: A borrower fails to repay its debt.
• Liquidity risk: You cannot easily sell an investment when you need to.
• Interest rate risk: Changes in interest rates negatively affect an investment’s value.
• Volatility: The investment’s value fluctuates significantly over time.

Not every type of risk applies equally to every investment.

A U.S. Treasury bond has very different risks than an investment in a small private business. Understanding those differences is important when deciding what level of risk makes sense for you.

What Is Return?

Return is essentially what you earn—or lose—from an investment.

If you invest $10,000 and eventually have $11,000, you’ve earned a $1,000 return, or 10%.

If you invest $10,000 and end up with $9,000, you’ve experienced a $1,000 loss, or a -10% return.

Returns can come from several sources, including:

• Interest
• Dividends
• Capital appreciation
• Business distributions
• Other investment income

The important thing to remember is that a higher potential return generally comes with a higher level of uncertainty.

Starting With the “Risk-Free” Rate

When discussing risk and return, financial professionals often start with something called the risk-free rate. The risk-free rate represents the theoretical return an investor could earn without taking meaningful investment risk.

In practice, U.S. Treasury securities are commonly used as a proxy for the risk-free rate because they are backed by the U.S. government. For example, if a Treasury security is yielding 4%, an investor might reasonably ask:

“Why would I invest in something riskier if I can earn approximately 4% with very little credit risk?”

That question is fundamental to how markets price investments.If an investor can earn 4% with very little risk, a riskier investment generally needs to offer the possibility of a higher return to make taking that additional risk worthwhile.

The Risk Premium

This additional return is often referred to as a risk premium. Imagine a Treasury investment provides a 4% return. Now imagine a corporate bond provides a 6% return. Why would an investor require an additional 2%?

Because the corporate bond carries risks that the Treasury does not—or at least not to the same degree. The company could experience financial difficulties. It could potentially default on its debt. The bond may also be less liquid. That additional 2% represents compensation for taking on additional risk.

This same concept applies throughout investing. The return an investor requires can generally be thought of as:

Risk-Free Rate + Risk Premium (Compensation for Risk) = Required Return

The exact calculation becomes much more complicated when valuing stocks, businesses, and other investments, but the basic concept is relatively simple. The more risk an investor takes, the more return they generally expect to receive as compensation.

Why Corporate Bonds Help Illustrate This

Corporate bonds are a useful example because they sit somewhere between government securities and riskier investments.

A company may issue bonds to borrow money from investors. Because investors are taking on the risk that the company may not repay them, they generally demand a higher interest rate than they would receive from a comparable Treasury security.

A financially strong company may only need to offer a relatively small premium over Treasuries.

A company with significant financial risk may need to offer a much larger premium to attract investors.

This is one reason corporate bond yields can be useful for understanding how markets think about risk. The higher the perceived risk of the borrower, the greater the return investors generally demand.

What About Stocks?

Stocks introduce another level of uncertainty. When you purchase stock in a publicly traded company, you become an owner of that business. Your return depends largely on how that business performs and how the market values it.

A large, established company may have relatively predictable operations, diversified revenue sources, and significant financial resources. A smaller company may have substantially more uncertainty. It might grow rapidly and produce an enormous return for investors. Or it might struggle, fail to grow, or eventually go out of business.

That is the trade-off. An investor may be willing to accept significantly more risk because the potential return is also significantly higher.

Small Businesses Provide an Extreme Example

Consider investing $100,000 into a small privately held business. If the business succeeds, your investment could potentially grow substantially. Perhaps the business doubles in value, triples in value, or even becomes worth many times your original investment. But what happens if the business has cash issues or pricing issues or you name it and eventually fails and goes out of business?

Your investment could be worth $0. You could potentially lose the entire $100,000. That is an enormous amount of risk compared with purchasing a highly diversified investment.

This is why investments in small businesses can potentially command very high expected returns. Investors are taking on business risk, liquidity risk, concentration risk, and many other uncertainties. The possibility of a large return is compensation for accepting those risks.

But remember:

High risk does not guarantee high returns.

It simply means there is a wider range of potential outcomes.

You could earn 50%.

You could earn 10%.

You could earn 0%.

You could lose 50%.

You could lose everything. That distinction is extremely important.

Risk Does Not Always Mean You Should Avoid an Investment

It would be easy to read all of this and conclude that risky investments are bad. That’s not necessarily true. Risk is not inherently good or bad. It is something that needs to be understood and managed.

A young investor with decades until retirement may be comfortable accepting significant market volatility because they have a long time horizon. Someone who needs the money next month may have a completely different risk tolerance. Similarly, someone with a large, diversified investment portfolio may be able to dedicate a small portion of their assets to higher-risk investments without putting their overall financial situation in jeopardy.

Don’t simply make the question:

“Is this investment risky?”

Instead make the question:

“Is the amount of risk appropriate for my situation?”

The Relationship Between Risk and Return

At a very high level, investments can be thought of along a spectrum.

A Treasury security may offer relatively low risk and therefore a relatively low expected return.

Investment-grade corporate bonds may offer somewhat more risk and a higher expected return.

Diversified stocks generally carry more volatility and uncertainty but also have greater long-term growth potential.

Individual stocks introduce additional company-specific risk.

Private businesses can introduce even more concentration, liquidity, and business risk.

This doesn’t mean every investment will follow this exact pattern every year. A stock can lose money while a Treasury investment earns money. A risky investment can outperform a safe investment—or dramatically underperform it. The relationship is about expected returns over time, not a guarantee of what will happen next.

So, How Much Risk Should You Take?

There isn’t one correct answer.

Your appropriate level of risk depends on several factors, including:

• Your age
• Your investment time horizon
• Your financial goals
• Your income
• Your emergency savings
• Your existing investments
• Your ability to withstand losses
• Your willingness to withstand losses

That last distinction is particularly important.

Your risk tolerance is not necessarily the same as your risk capacity.

You may be comfortable watching an investment fall 30%, but if you need that money to buy a house next year, you may not have the financial capacity to take that risk.

Understanding both sides of the equation can help you build a more appropriate investment strategy.

My Two Cents

The most important thing to understand about risk and return is that there is no such thing as a free lunch.

If someone promises you an unusually high return with virtually no risk, you should be skeptical.

Higher potential returns generally require you to accept additional uncertainty.

That doesn’t mean you should avoid risk. In fact, taking an appropriate amount of risk is often necessary to build wealth over the long term.

Instead, understand what risk you’re taking, why you’re taking it, and whether you can afford the potential downside.

The goal isn’t to eliminate risk.

The goal is to take the right amount of risk for your financial situation.

– Brendan Tiedeman, CPA, CVA

Disclaimer:
This article is for educational and informational purposes only and should not be considered tax, legal, investment, business valuation, or financial advice. Investment returns are not guaranteed, and investing involves risk, including the possible loss of principal. Individual circumstances vary, and readers should consult with a qualified financial professional before making investment decisions.