The risk-return tradeoff

Overview

The balance between risk and return is among the fundamental principles of investing: the more return you want, the greater the risk you will usually have to assume. There is no dependable method of avoiding this. 

Assets that offer higher returns do so because investors must be paid for the additional chance that things might go wrong. It does not follow that taking risk guarantees a return, what it does mean is that, on average and over the long term, markets price riskier assets so that they provide a higher expected return than safer ones, or else no sensible investor would hold them. 

Whether or not that extra expected return actually materialises in any given year is a quite different matter.

Ordering assets by risk and return 

A simple and widely used way of showing the trade-off is to list the different asset classes in order of their usual level of risk and return, starting with the lowest and going up to the highest. 

Cash and cash equivalents, for example, savings accounts and money market funds, have a very small chance of suffering a loss, but their returns do not keep up with inflation and in some cases are even below it. 

Government bonds, since they are backed by a government's ability to tax and borrow, have a low probability of default, even though their prices do change in response to interest rate movements. 

Corporate bonds offer higher yields than government debt as compensation for the possibility that a company might fail to repay. 

Equities give higher long-term expected returns, but their prices can vary a great deal and a company may lose most or all of its value. 

With regard to alternatives, such as private equity, hedge funds, property, and commodities, they often have the highest possible returns, but are also the least liquid, the most difficult to value, and most susceptible to shocks that affect the manager or the market as a whole. 

This sequence reflects the typical, long-term patterns rather than making any assurances: government bonds can underperform cash in bad years, and equities may go for a full decade without outperforming inflation. 

The 'risk premium' that is expected from riskier assets is a historical tendency, not a contractual guarantee. 

Related concepts

Diversification is the main approach that investors use so as not to abandon the possibility of earning returns, they achieve this by spreading their money among assets which do not all move in the same way, in such a manner that losses in one area can more than be made up for by gains or by stability in another, even if a general downturn may still cause most of the assets to fall. 

Risk tolerance and risk capacity are often confused even though they have distinct meanings: risk tolerance is a psychological issue, it means the amount of loss an investor can accept without becoming anxious and selling when it is most disadvantageous,  whereas risk capacity is a financial matter, it refers to how much loss an investor can actually afford, considering their income, the length of time they have, and their obligations, regardless of how they feel about it. A sound investment strategy must consider both of these factors, since it is possible for a person to be comfortable with a high level of risk yet still not have the financial cushion to support it.