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.
This is a well known theory about the risk “curve” and you describe it very well. However I am not entirely sure about the theory and we perhaps we need to firstly define risk, which in this case might be “the chance of permanent loss of capital”? So risk is actually more related to the price you pay for an asset and its potential/actual return. So if I buy a UK government bond or one third of the intrinsic value for a blue chip stock which is more risky? Sorry, in a bit of a rush but hopefully you get the idea.
“Generally, the greater the risks of holding a particular asset, the greater the potential return for the investor.”
This is true. Or at least we seem to all believe it’s true. I’ve never measured it, but I trust that other people do and that it is built into the price of the assets.
Generally. (And I think you are quite right to write it this way, TI — the mathematician in me is just fascinated by diving down to the next level)
We all know what risky means, right? But hang on, isn’t Gold a safe haven? I’m getting killed on that at the moment. What about bonds? Ten-year treasuries are safe as houses. But I’m too scared to hold them.
“Risk” and “Return” always show up in the same sentences. And while I can very tightly define “return” (and I would always fold together yield and capital appreciation into total return), I find it very hard to define “risk”. As a mathematician, I think risk is probably the forecast distribution of returns, which is probably best guessed by the historical distribution of returns — so that’s a shape rather than a number. Yikes. What does “greater risk” mean in the context of a shape? Probability of total loss? Probability of any loss? Variance of the distribution of returns (ie volatility)? Over what period? One-day returns, one year returns? Does that distribution behave nicely (ie is it approaching a Normal?) or does it have long tails and black swans?
Hmmm. Complicated. Best just call it “risk” and we can all know it when we see it…
In engineering, risk is probability multiplied by impact (we try to assign values to these). I guess the same is true in investing – there are still two elements to risk, the impact of an event occurring and the chance of it occurring. High risk events are either low impact/high probability or high impact /low probability. An example of the former be might be the risk of the UK stock market generating negative returns in 2016. An example of the latter might be a major default somewhere around the world.
@Mathmo — Indeed. I’ve written tonnes on the more esoteric nuances of risk, which readers can discover via typing Risk into the Search bar top right, or indeed following some of these links.
But just on the points above, there are multiple responses.
Firstly, time scales are all important. The chances of shares being up or down today are very nearly a coin toss (from memory something like 50.01% chance of higher). You have to toss the coin a lot of times.
Secondly, you talk about assets being down despite being safe havens etc. And someone earlier this week said “if the expected returns from bonds are lower then it’s best not to hold them.” This is all waving around the wrong end of the stick.
As a mathematician, you don’t need me to tell you about probability distributions and curves. There is a chance that AAA UK government bonds will default. It’s extremely tiny (it would probably require revolution, and even after that willful Pol Pot style wanton self-destruction).
If that occurs it doesn’t mean that the perception of UK government bonds as very safe was not true. If there’s a 1/10,000 chance of something happening, and it does happen, that in itself does not mean the estimate was wrong.
I see people making this mistake in thinking all the time, and it’s crucial I believe to rid one’s mindset of it when investing.
Risk is the chance that more than one thing can happen. If something unexpected does happen, that just means that something unlikely happened.
@Everyone — I would prefer comments on this article not to turn into a discussion about perceived risks and rewards *today* please, since they’ll all be different in a year’s time. This is the big picture stuff.
@China Nigel @Matt — See these two articles for more on this:
Risk and Investment
The First Law of Thermodynamics and Risk
Quite right TI. I was just being curious…
Big picture: each individual asset has an expected return and a risk (ie a spread of likely returns around that average return). By holding a mix of uncorrelated assets you get to have a similar average return but with a lower spread of returns. The problem is that we neither know the spread of future returns, nor whether assets are truly uncorrelated.
If you are betting on coin tosses, then £1 on 5 coin tosses has a probability of just 3% of losing £5. £5 on a single coin toss has a probability of 50% of losing £5. They both have the same average return.
The trick seems to be not changing your mind mid toss. 😉
If you hold the bond to maturity then in theory you get back the bond face value.
However, how does this work if you buy units in an index fund that holds a % of government bonds. Do these ever hold to maturity ? If not does this affect anything?
I think (I’m uncertain on this) I see risk as “uncertainty of capital/yield/total returns”, which might be represented by a distribution curve of probable capital, yield or total returns at some future horizon (depending on which is being considered and the duration). Imagine a bell shaped curve drawn at 90 degrees on the right hand axis, or one of those fan-out heat map chart things.
From the coin tossing example above, we can see the most likely outcome of each game from the distribution curves – one contains a lot more uncertainty than the other. And there are also different time horizons implied (by the number of tosses).
I think this also illustrates the ‘risk reduction’ from diversity. The ‘classic’ example being to hold some bond/cash/etc which has less uncertainty about capital gain/loss and less uncertainty of yield, which narrows the distribution curve both at the top and the bottom on both capital value and yield ranges. That is: a diversified portfolio has less uncertainty of outcome than a non-diversified one. In other words the highs are not as high but the lows are not as low. You can still loose, but probably not as much, and you probably won’t gain as much either.
I think this view also takes into account ‘only invest in riskier things if you have a long time horizon’. As with the coin tossing, the longer you play the game the less uncertainty there is in the outcome.
There must be something wrong with this view of ivestment risk or it would be seen more often. I’m not even certain that it matches my own (flawed) internal model when making investment decisions.
Interestingly, it could be used to describe index tracking as ‘lower risk’ in comparison to active management. Here, rather than absolute return, the question is relative returns. A monkey throwing a dart at a catalogue of index tracker funds will have less uncertainty in return compared to a monkey throwing a dart at a catalogue of active funds. And that is how I started out investing: faced with a catalogue of active funds which couldn’t demonstrate a track record of beating the index, I picked the lowest cost index fund I could find. Since then I have sinned, and mostly repented.
Thanks for this timely and clear exposition of asset classes in a manner that satisfies Occam’s Razor principle. Pluralitas non est ponenda sine necessitate.