Risk and return is the most important thing you must understand about investing. Risk and return are the two balancing components that make up all investments. It is like Yin and Yang, Light and Dark, Ketchup and Fries, Curry and Rice and.. well, you get the idea. Before you put your money into any investment you must first consider what are the risks associated with the investment. After that, you can look at the returns you can get.
Risk and Return: What is Risk?
Risk is, simply put the measure of volatility associated with an investment.
In non-financial speak that means how likely the return on the investment will go up or down. The more risky an investment is, the more it will go up and down. Investments can generally be categorised by their level of risk.
Low risk investments
Think of risk like a roller-coaster. A low risk investment is your kiddy roller coaster – mostly flat with just enough ups and downs so that Lil’ Jonny won’t spew his lunch over his Ben 10 T-shirt. It is very tame but you’re not likely to lose your meal over it. A low risk investment protects your capital (that is the amount of money you first invest) and is designed to prevent you from suffering huge losses. Conversely, a low risk investment is unlikely to give you huge gains either.
Some examples of low risk investments include Term Deposits, Savings Accounts and Government Bonds. As an average retail investor (IE people with a modest amount of cash to invest) we can put money into Term Deposits from anywhere between 6 months to 5 years and get a decent return on investment of say 2% to 4.5%. These are low returns if you are looking to save for retirement. They are good returns if you just want to park your cash in a secure investment until you are ready to use it for something better (like a first home deposit or starting your own business!).
High risk investments
On the opposite end are high risk investments. A high risk investment is your ‘Super Screamer Pants-Wetter of Doom Roller Coaster’ that only people above 150cm (that’s about 5’2″ for you imperial types) can ride in. Massive highs, massive drops but you are in for one hell of a ride! These are often the ones that make the news. Everyone loves reading about investors winning big on bets they made on highly risky new company stocks. Conversely, people also love reading about investors losing big on bets they made on really risky investments. With high risk investments, you can potentially get get high returns, but you can also similarly suffer huge losses.
Some examples of high risk investments are stocks of new companies, financial derivatives and everyone’s favorite – cryptocurrency! Getting decent returns on high risk investments is all about timing. If you get your timing right, you can come in at a time when the price of investing is low and exit (sell off) when the price is high. In theory that works. In reality, it is hard to get the timing right on highly risky investments. Also, emotions, personal judgments and morals come into play when dealing with highly risky investments. Some investors like the thrill and will trade in risky investments on a daily basis, hoping to make small amounts of profit on each trade but doing trades in high volumes. Some investors take the longer view, investing in risky investments, confident that over a long period of time (5 to 10 years or more) the prices will trend upwards.
Risk and Return: What is Return?
Return is what you get from investing.
Let’s say you put $1,000 into a term deposit for 1 year. After 1 year you get back $1,100. The extra $100 is your return on investment, which works out to about 10% of your original $1,000. So we can say that you made a return of 10%.
Return also means the expected amount of money you can get from an investment. When investing in any asset, you have an expectation of the amount of return you can make. Which brings us to the relationship between risk and return:
The higher the risk, the higher the return
Or more accurately: ‘The higher the risk, the higher the EXPECTED return’.
It is important to clarify this statement. High risks don’t always equal high return in real life. This is because, high risk investments can also lead to huge losses. Conversely, low risk investments are more secure and are less likely to lose.
If that’s the case, then shouldn’t we all be investing in low risk assets?
NO
Again, let’s go back to the first lesson about financial goals. For some people, investing in low risk investments makes sense, they want their money in a nice, secure place that will grow just enough to beat inflation. But for people with larger financial goals, they will want to invest in an investment that can generate a higher return. It is important to note that with certain types of high risk investments (like stock markets) – the returns tend to gain more over time. Let’s take the NZ Top 50 index (The top 50 performing stocks in the NZ stock exchange) as an example:
I won’t get into too much detail. The point I’m trying to make is that if you invested $1,000 in 2013, you would have more value in the NZ Top 50 even during the 2020 Covid Crash then what you started off with. (And heck of a lot more in 2021!!). That being said, if you invested in late 2019, you would have lost a lot of value during the 2020 Covid Crash, but you would STILL have more money than what you started off with in 2021. This is because stock markets tend to gain more over a longer period of time.
If you are looking to make a quick buck with high risk investments – you’re better off playing lotto. This is because high risk investments can gain and lose a lot of value in a short period of time.
But of course not all investments behave the same way. So in the next article, we will briefly look at some easy to understand investments that you can get into!