When it comes to investing, risk and return come hand-in-hand – you cannot have one without the other. As an investor, typically, you need to take on more investment risk in order to realize higher investment returns. While this is not always the case, in general, investors should expect this relationship to hold. If an investor is unwilling to take on investment risk, they should not expect returns above the risk-free rate of return.
The relationship between investment risk and return is a fundamental investment principle.
If an investor desires to achieve higher investment returns, they must be willing to accept greater investment risk.
There are many ways to define risk. However, in the context of financial management and investing, it can be defined as either the probability of losing ‘X’ amount of an investment over a given time period or as the return volatility of an investment over a given time period.
When an investor considers purchasing a very high-risk investment, they should expect to lose some or possibly even all their investment. For example, if an investor owns shares (stock) in a high-risk company and that company goes bankrupt, they are likely to lose all of their investment.
Return volatility is typically defined by standard deviation. This statistical figure measures the dispersion of a dataset relative to its mean, calculated as the square root of the variance.
Standard deviation is usually applied to an investment’s annual return to gauge return volatility. A greater standard deviation indicates greater investment volatility and, therefore, greater risk.
A return (also referred to as a financial return or investment return) is usually presented as a percentage relative to the original investment over a given time period. There are two commonly used rates of return in financial management.
Nominal rates of return that include inflation
Real rates of return that exclude inflation
An investment return can come in a wide range of forms, including capital gains, interest, dividends, or rental income in the case of real estate. Again, these investment returns are usually presented as a percentage. In its simplest form, nominal investment returns can be calculated using three variables:
The initial investment
The ending value of investment
The investment time period
Let’s assume an initial investment of $100 that grows to $120 in one year. The investment return is calculated as follows:
Nominal rate of return = ($120 / $100) – 1 = 0.2 or 20%
As mentioned above, this is the nominal rate of return. Let’s now assume that the inflation rate during this one-year period was 3%. We calculate the real rate of return by taking the nominal rate of return and subtracting the inflation rate.
Real rate of return = 20% – 3% = 17%
Real rates of return better reflect the purchasing power of investment returns.
In general, higher investment returns can only be generated by taking on higher investment risk. However, this does not hold in every single scenario. For example, by diversifying a portfolio of investment assets, a comparable return can often be generated with less risk than an undiversified investment portfolio. That being said, there is a limit to the effectiveness of diversification as a portfolio grows increasingly large.
The risk-return trade-off is a foundational investment principle. There are many different types of investments and asset classes, such as money market securities, bonds, public equities, private equity, private debt, and real estate, to name but a few. All of these asset classes come with varying levels of investment risk. Having investments with different risk-return profiles helps meet the different risk appetites of various investor groups.
Consider the above graph. Asset class #1, risk-free bonds, are issued by governments and, in most cases, are considered “risk-free” since a government can print money to pay off its debts. Because of this, risk-free bonds are the safest asset and consequently have the lowest investment return.
Moving up the risk-return spectrum, we can see that each asset class gets riskier. However, the potential investment return associated with each asset class also increases.
Asset class #5 is private equity, which involves investments in private companies that are not publicly traded on an exchange. These investments are typically riskier than public equities and include additional risks such as liquidity risk. However, because of these additional risks, private equity also offers investors the highest potential investment returns.
Thank you for reading CFI’s guide to Risk and Return in Financial Management. In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful: