Some assets are riskier than others, both in terms of the security of the income they generate and the potential for capital loss. Generally, the higher the risks of holding a particular asset, the higher the potential return for the investor.
Cash is the safest asset since its value is by definition guaranteed. If placed in a cash savings account, cash generates an income that varies with prevailing interest rates.
Government bonds such as U.S. Treasuries and UK Gilts pay a fixed income to the holder. As the interest rate available on cash deposits rises and falls, the relative attractiveness of the fixed income from a government bond changes. This increases or decreases the bonds’ value to an investor and hence its price, even though the absolute income it pays stays the same. Government bonds are guaranteed by the government, so investors in stable countries such as the US and the UK will get back the face value of the bond if they hold it to maturity.
Other assets such as stocks, corporate bonds and property provide an income and fluctuate in value, but without the security of government guarantee. Companies pay dividends, but the amount is not guaranteed. An office building will generate a rental income, but this can be reduced by vacancies. Both stocks and property as a class tend to increase in value over time, but they can fall in price in the short to medium-term or individually become entirely worthless: a company can go bust or a house fall down.
Owners of riskier assets demand greater returns for holding such assets, otherwise they will sell and put their money into less risky assets. For instance, if you can get 5% on cash savings, you are unlikely to buy riskier corporate bonds also yielding 5%, unless you think interest rates on cash are going to fall fast.
With cash, your money is safe. Corporate bonds can default on payments and fall in value. Therefore you’ll only buy them in return for a higher income compared to cash.
Capital risk/return
Returns on holding an asset don’t have to come by way of income, which further complicates the risk/return picture.
A particular share’s dividend yield will often be far lower than the income paid by a government bond or cash, even though holding the share is clearly far more risky. In this case the owner of the share expects to be compensated by capital appreciation – the share going up in price.
Investors must try to choose the mix of assets that provides the best return for the level of risk that they are prepared to take.
Diversifying a portfolio between several different asset classes will reduce the overall risk being taken on by the investor, since some assets rise in price as others fall in price.
Other factors such as the time value of money must also be considered when evaluating risk.
See more financial terms in the Monevator glossary.
ISA reminder! British readers have until April 5th to open a 2009-2010 ISA for tax free saving and investment. Legal and General is running a cashback deal for its share ISAs, including its popular index tracking ISAs.
Filed under: Financial glossary
