Investment Risk and Return

Risk - return trade off

Risk refers to the degree to which an investor may lose his or her investment. Return refers to how an investment performs; that is how much it gains or loses over a period of time.

Different types of asset classes, such as stocks, bonds, and money market securities, have varying levels of risk and return potential. Generally, the higher the potential return on an investment, the higher the risk involved in pursuing that return. This is called risk/return tradeoff. While some people can handle the equivalent of financial rollers-coaster, others are terrified to climb the financial ladder without a secure harness. Deciding what amount of risk you can take while remaining comfortable with your investments is very important. 

Type of Risks

Your investments are subject to varying degrees of specific risk, market risk, and inflation risk.

  • Specific risk (unsystematic risk) is the risk of price change due to the unique circumstances of a specific security, as opposed to the overall market. The unique circumstances are specific to a company or industry that is inherent in its security. Specific risk is also known as “unsystematic risk", "diversifiable risk" or "residual risk". 
  • Market risk (systematic risk) is the possibility of your investment decreasing in value over a given time period simply because of economic changes or other events that impact large portions of the market. The risk is inherent to the entire market or entire market segment. Market risk is also referred to as “systematic risk” or "un-diversifiable risk".
  • Inflation risk is the chance of diminishing purchasing power over a period of time due to rising price (inflation).

Whereas market risk (systematic risk) affects a broad range of securities, specific risk (unsystematic risk) affects a very specific group of securities or an individual security.

Generally, as the market risk of an investment increases, its inflation risk decreases, and vice versa.

Risk Measure

Extraordinary gains are won only through excessive risk taking, which often means tremendous volatility that is ups and downs in short-term returns. While no single risk measure can predict with 100% accuracy how volatile security will be in the future, studies have shown that past risk is a pretty good indicator of future risk. In other words, if a security has been volatile in the past, it's likely to be volatile in the future. 

Two common yardsticks for measuring a security's risk are standard deviation and beta. While the standard deviation of a security measure the total risk, which is both the specific risk and market risk, the beta of a security is a measure of how much market risk a security faces

Managing Risk

You can manage your exposure to investment risks through proper diversification and asset allocation. 

Specific risk can be reduced or virtually eliminated from a portfolio through appropriate diversification. Investing in many different assets reduces the volatility of the portfolio because up and down of individual asset cancel each other out. 

Because the specific risk can be eliminated, the really matter is market risk. Investors reward only market risk. Market risk can’t be eliminated through diversification, but can be managed and reduced by asset allocation. There is a trade-off between risk and return for asset classes. Historically, stocks had higher risk and return than bonds had. 

Market risk and inflation risk should be balanced according to investment time horizon. For instance:

  • If you’re investing over the short-term (low inflation risk), you want to reduce your exposure to market risk while increase your exposure to inflation risk by purchasing bonds and cash equivalents.
  • Investors saving for retirement (high inflation risk), on the other hand, may want to minimize the potential for inflation risk while increase the market risk by allocating a greater portion of their assets to stock investments.