Last updated in May 2020
The relationship between risk and return often seems to be a linear one. Low returns on one end, and high risk on the other end. However, in reality, the picture is far more complex. Return and risk are two sides of the same coin but their interaction is not as apparent.
For beginner investors and ordinary people, the relationship between risk and reward can be hard to understand. This post aims to show you that investing is not an all-or-nothing world. Everyone can learn to manage their investment risk and still maintain adequate returns.
Monethalia does not offer financial advice. Should you take any action based on the information provided, Monethalia will not be liable for the outcome.
Table of Contents
The relationship between risk and return when investing
Definition of risk and return
Risk is the chance of you losing your investment. There is an inherent risk to everything because that is what it means to be alive. However, some actions are riskier than others.
- For example, if you put a £10 note under your pillow, the risk is that someone could break in and steal it or the house could burn down, thereby destroying the note.
- Or you could put your £10 into a bank account. Money in your bank is normally protected but you could still lose it if the economy breaks down or a severe disaster happens.
- You could also invest £10 in the stock market buying stocks of a single company. If that company performs poorly, your money would be gone.
All three scenarios have risks associated with them. What differs is the likelihood of the described events to happen. Therefore, the risk is higher in those cases with a higher likelihood of occurring.
Return means the money you make from your investment. For example, if you lend £100 to your friend and they repay you £110, your return would be £10. Rather than ‘return’, it is normally more appropriate to speak of ‘potential return’. This is because your friend could also choose to not repay you (or investments could fall through).
The relationship between risk and potential return is often depicted as a straight line. Note that the focus lies on ‘potential’ as you the risk of loss would be an identical line.
A classic low-risk low return investment would be a current account. The risk of losing money is low due to the Financial Services Compensation Scheme (FSCS). In line with this, the return is also low with interest rates often staying below inflation.
An example of high-risk investments would be buying bitcoin. Unless you have the experience and skill, you are likely to lose money over time due to its hard-to-predict nature. You may experience short-term gains but overall, you are likely to end up as the loser.
In reality, there are more ways to invest than just current accounts and bitcoin. There are many different investment types (asset classes). All of these have different risk-return profiles that loosely match the curve but are not identical to it.
For example, well-diversified index funds are one way to maintain an adequate return with comparatively low risk. With index funds, you can still lose money short-term, but over the long term, you are likely (but not guaranteed) to make a profit.
There are low-risk high-return investment options. However, if someone describes their investment as such or you are offering their investment service to you, this is likely a scam. But there are also people who genuinely make money with high-risk investments. Some people manage to reduce risk while maintaining high returns. This is because they spend time studying the market and know its ins and outs.
In a way, a comparison can be drawn to movie stuntmen. They manage to turn high-risk tasks such as jumping through fire into a low-risk task through knowledge and practice. That being said, someone without proper training would just dive straight into their death.
Modifying the relationship between risk and return
Knowledge and skill can lower the risk of otherwise high-risk investment (note that the risk will never be zero though). In line with this, there are also ways to modify investment risk without being an expert:
One way to minimise the risk is to diversify your investment. This means buying stocks, investing in bonds, holding some cash, etc, at the same time. Another way to diversify investments is to buy an index fund which is a basket holding many different stocks. This way you are covered if one investment performs poorly.
Additionally, time plays a role as well. Being invested for longer means your investments have time to recover after a market downswing.
Having the proper mindset is perhaps the most important factor. Many investors lose money because they sell in a panic when the market falls. Thus, your investment decisions should always be guided by logic rather than emotion.
The relationship between risk and return summary
The relationship between risk and return is often presented as linear. However, in reality, there are various asset classes, each with a unique risk-return profile. Selecting an asset class according to one’s risk tolerance is crucial.
Investment risk can be reduced by spending time studying the market. Knowledge and experience are important factors. You can also reduce your risk through diversification, for example by using an index fund to spread your risk.
If you feel ready to invest now, you may want to learn how to invest with confidence as a beginner.
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