Risk versus Returns

Every investment has an attached risk

'Just buy this blue-chip stock, there's no risk at all.' For most people who invest in shares there is a good chance that you've heard someone say this before. For most people who just put their money away in bonds or deposits, one of your main reasons for this probably is -'I don't want to take any risk at all, I just want my money safe.'

Are these statements true? Is investing in bonds or deposits completely risk-free? Or investing in blue-chip stocks necessarily very low risk? NO.

Whenever more than one outcome is possible from an investment, there is always some amount of risk. Only the level of risk is different.

Use risk to analyse expected returns

While investing, risk is measured to evaluate the kind of returns you should expect from the investment. Or your return expectations should be based on the level of risk you can bear. In principle, the higher the risk, the higher the returns that should be required.

Empirically returns across various asset classes show that investment in equity shares give the highest level of returns in the long-term, followed by corporate bonds and deposits and lastly bank deposits and government debt. Not surprisingly, the level of risk is also in the same order.

You might be saying - how can debt be risky? It is.

Companies that run into financial trouble could delay your interest payments or even default on paying back your money. Even government debt has some amount of risk. How? Simply put, governments like companies also face the risk of financial problems. However, lack of funds for a company could result in the company defaulting on a loan repayment. But a government can always print more currency and repay its borrowings. So you will get your money back. BUT, there is a hidden cost (risk). Printing more currency is likely to lead to higher inflation and hence lower real returns on your investment (see our article Impact of Inflation to understand about real returns).

Agreed that the chances of governments or well-managed companies getting into serious financial troubles are low. But that is only difference in the level of risk. There is a risk attached, and that cannot be questioned.

Understanding risk vs return essential for good financial planning

You might ask - why is it so important to understand the risk versus return relationship? Because if you don't, it is quite likely that your investment returns will not match your risk profile and consequently you are not managing your hard-earned money well. A wasted opportunity, as even a small difference in your investment returns (at the same level of risk) can make a BIG difference to your financial wealth (due to the astounding Power of Compounding).

To understand the importance of managing your money well read Guide To Financial Planning. This article highlights why financial planning is not as difficult as it sounds and how you can easily make your hard-earned money work for you.

Also you can use our Risk Analyser to understand your risk profile (both your risk-taking capacity and your risk tolerance level) and read The Need To Diversify to understand how you can increase your expected returns while not increasing your level of risk.