Some assets are riskier than others, both in terms of the security of the income they generate and the potential for capital losses and gains.
This relationship between risk and return is one of the cornerstones of investing.
Generally, the greater the risks of holding a particular asset, the greater the potential return for the investor.
Cash is the safest asset since by definition its nominal value is guaranteed. If placed in a savings account, cash generates an income that varies with interest rates. But its value1 does not change.
Government bonds such as U.S. Treasuries and UK Gilts pay a fixed income to the holder. They are also redeemed at par value on a given maturity date, which means that when you buy a government bond you can know exactly what return you’ll achieve – provided you hold it to maturity.
This combination of a fixed coupon and a known repayment date and sum makes US and UK government bonds very safe investments.2
This does not mean you can’t lose money through trading government bonds.
As the interest rate on cash rises and falls, the relative attractiveness of the fixed income from a government bond changes. This increases or decreases the bonds’ value to investors. Accordingly, the amount an investor will pay for the income stream from a bond (i.e. its price) will fluctuate, altering the yield it offers new buyers – even though the absolute cash paid out by the bond remains the same.
Government bonds are guaranteed by the government, which is another attractive feature. Investors in stable countries such as the US and the UK can be confident they will get back the par/face value of their government’s bond if they hold it to maturity.
For these reasons government bonds are often termed ‘risk-free assets’ (although in extreme situations no investment is totally safe).
Corporate bonds similarly provide a known income, a redemption date, and fluctuate in value along the way – but they do without the security of a government guarantee. This means they are riskier, and so should always yield more than government bonds.
Other assets such as shares and commercial property are riskier still.
- Companies pay dividends. But the amount paid is not guaranteed.
- An office building will generate a rental income, but this can be reduced by vacancies.
Both shares and property as a class tend to increase in value over the long-term, but they can fall in price in the short to medium-term and individually become worthless – a company can go bust or a house fall down.
Even if the worst does not happen, there is no redemption date or price with shares or commercial property when you can trade in your holdings for a known sum as you can with bonds, which further increases the risks of owning such assets.
More, more, more
The good news is that this greater risk opens up the potential for higher returns.
That’s because investors in riskier assets demand greater returns for holding such assets – otherwise they would sell up and put their money into less risky assets.
For instance, if you can get 3% on cash savings, you are unlikely to buy riskier corporate bonds also yielding 3%, unless you think interest rates on cash are going to fall fast.
With cash, your money is safe. Corporate bonds can drop in value and default on payments. Therefore you’d only buy bonds if you expected a higher return compared to cash.
This principle extends along a curve that roughly tracks high risks for higher potential returns.
With shares, there’s no fixed income, no redemption price/date, and no government guarantee backstopping your investment.
No surprise then that shares also offer the highest potential returns.
Gains on holding an asset don’t have to come by way of income. This 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, for instance, even though holding the share is clearly far more risky.
But this does not necessarily violate the risk/return principle.
Rather, the owner of the share expects to be compensated for the extra risk by capital appreciation – that is, by the share price rising.
They’ll usually expect the regular cash dividend paid by the company to increase over time, too, in contrast to the static payment from a bond.
Balancing risk and reward
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 can enhance expected returns while reducing the overall risk being taken by the investor, since some assets may rise in price as others decline.
Other factors such as the time value of money must also be considered when evaluating risk.
See more financial terms in the Monevator glossary.
- Ignoring inflation [↩]
- Note: Before anyone starts ranting in the comments, safe does not mean “high return”. [↩]