Risk and Return – The Pillars of Every Investment

INVESTING PILLARS SERIES – PART 1

The Trade-off You Can't Ignore

In the world of investing, the first lesson you should learn is about risk and return. Imagine two paths—one filled with uncertainty but offering higher rewards, the other safer but providing only modest gains. Which would you choose? Your answer lies at the heart of every investment decision you will ever make.

There is no right answer for this question. There are moments in which one of them will perform better and there are moments in which the other will perform better, assuming performance is what the investor is looking for. Even professionals can only estimate the amount of risk an investor is willing to take or bear.

The art of balancing risk and return is the most critical concept to master if you want to grow your wealth over time. But it's not just about choosing the riskiest option for the highest reward. It's about understanding what level of risk fits your financial goals and personality, so you can create a strategy that lets you sleep soundly at night while still building a bright financial future.

In this article, we’ll break down the essentials of risk and return, explore the different types of risks, and explain how to develop a strategy that works for you. Let’s begin by demystifying the relationship between risk and return.

The Inseparable Link Between Risk and Return

At its core, investing is a game of probability. You make decisions today based on potential future outcomes, none of which are guaranteed. This uncertainty is what we call risk. Risk is measured in the markets by beta, a metric of volatility.

But why take on risk at all? The answer lies in the concept of return. In investing, the greater the potential return, the higher the risk involved. For example, stocks generally offer higher returns than bonds, but they also come with greater volatility. On the other hand, government bonds are considered safer, but they typically offer much lower returns.

The image below shows the total real return as well as the annualized real return for every asset class from 1802 to 2012. The total risk for each class is relative to the total return for the same class.

This dynamic is what’s known as the risk-return trade-off. To earn higher returns, you need to accept a higher degree of uncertainty. Understanding this balance is critical to making informed investment decisions.

There’s no such thing as a high-return, no-risk investment. This relation is usually seem in scams. In the words of the free-market economist Milton Friedman:

“There is no such thing as free lunch.”

But the key question remains: How much risk should you take?

Assessing Your Risk Tolerance

Risk tolerance is the balance between your ability and willingness to endure investment losses in pursuit of potential gains. This is not just a technical consideration—it’s a deeply personal decision shaped by multiple factors unique to your situation. Understanding your risk tolerance is essential for creating an investment strategy that aligns with your goals and emotional comfort level.

Key Factors Influencing Risk Tolerance

• Age:
  Younger investors typically have a higher risk tolerance because they have more time to recover from potential losses. For example, a 25-year-old saving for retirement can afford to take more risks than someone nearing retirement age.
• Financial Goals:
  Your investment timeline plays a critical role. If you’re saving for a goal decades away, such as retirement, you might take on more risk to maximize growth. Conversely, if you’re saving for a short-term goal, like buying a house in two years, you’ll likely prioritize preserving capital over taking risks.
• Income and Financial Security:
  Investors with a stable, high income or ample savings can typically afford to take on more risk. In contrast, those with uncertain income or limited financial security may prefer conservative investments to safeguard their capital.

The investors Risk-Tolerance Scale has the following pattern:

Understanding the Risk-Tolerance Scale

To determine where you fall on the risk-tolerance spectrum, consider these questions:

• How comfortable are you with short-term losses for the possibility of long-term gains?
• During a market downturn, are you likely to stay calm and stick to your strategy, or will you feel the urge to sell and cut your losses?

Your emotional reaction to market volatility is as important as your financial capacity for risk. Panic selling during downturns can derail your long-term goals, so aligning your investment strategy with your risk tolerance is critical.

Which Type of Investor Are You?

Investors are generally classified into three categories, conservative, moderate or agressive, as shown on the image above, although some investor combine elements of more than one of them, or even different profiles as a form of diversification style. Let's go deeper into each one of these three:

Conservative Investor

Prefers stability and capital preservation over high returns. Risk tolerance is low, and they avoid investments that could lead to significant short-term losses.

• Examples of Investments:
  • Government bonds (e.g., U.S. Treasury Bonds).
  • High-quality corporate bonds.
  • Money market funds or savings accounts.
  • Dividend-paying blue-chip stocks with low volatility (e.g., Johnson & Johnson).
  • Real estate investment with steady rental income.

Moderate Investor

Balances risk and reward, seeking growth while still protecting a portion of their capital. Risk tolerance is medium, and they are comfortable with some market volatility.

• Examples of Investments:
  • A mix of stocks and bonds (e.g., 60% stocks, 40% bonds).
  • Index funds or ETFs that provide broad market exposure (e.g., S&P 500 ETF).
  • REITs (Real Estate Investment Trusts) for moderate growth and income.
  • Balanced mutual funds.

Aggressive Investor

Focuses on maximizing returns, often at the expense of short-term stability. Risk tolerance is high, and they are willing to endure market volatility and potential losses.

• Examples of Investments:
  • Growth stocks, including tech companies (e.g., Tesla, Amazon).
  • Small-cap or emerging market stocks with high growth potential.
  • Venture capital or startups.
  • Cryptocurrencies (e.g., Bitcoin, Ethereum).
  • Leveraged ETFs or options trading.

A Strategy for Beginners

If you’re new to investing, it’s wise to start on the conservative side. Gradually increase your exposure to riskier investments as you gain experience and better understand market dynamics. This measured approach allows you to build confidence and avoid costly mistakes.

It’s also important to allocate only a small portion of your capital to investments you don’t fully understand. As your knowledge and comfort grow, you can expand your portfolio to include a broader mix of assets.

By thoughtfully assessing your risk tolerance and tailoring your strategy accordingly, you’ll be better equipped to weather market ups and downs while staying on track to meet your financial goals.

Types of Risk You Need to Know

When people talk about investment risk, they're often referring to market risk—the chance that the value of your investments will decline due to changes in market conditions. But there’s more to it than that. Let’s take a closer look at the different types of risks that every investor should be aware of:

1. Market Risk: The risk that the value of your investments will decrease due to economic, political, or other market-wide events. Stocks are particularly vulnerable to market risk, while bonds and other assets can provide more stability. Example: During the COVID-19 pandemic in early 2020, stock markets worldwide experienced sharp declines as uncertainty and fear spread. Even fundamentally strong companies saw their stock prices fall, demonstrating the vulnerability of equities to market-wide events.
2. Interest Rate Risk: This affects fixed-income investments, such as bonds. When interest rates rise, the value of existing bonds tends to fall, since new bonds are issued with higher yields. Conversely, when rates fall, existing bonds become more valuable. Example: If you hold a bond with a 3% fixed annual coupon and interest rates rise to 5%, new bonds will offer higher yields, making your bond less attractive. As a result, its market value will decline if you decide to sell before maturity.
3. Inflation Risk: Inflation can erode the purchasing power of your investment returns. If your investments don’t outpace inflation, you could actually lose money in real terms, even if your portfolio grows nominally. Example: If you earn a 4% annual return on a portfolio but inflation is running at 5%, your real return is -1%. Over time, this erosion of purchasing power could severely impact the effectiveness of your investments, especially for long-term goals.
4. Credit Risk: This refers to the possibility that a borrower will default on their debt obligations. It’s a key concern for bond investors, especially those holding corporate bonds or lower-rated bonds, which have higher yields but also higher risk of default. Example: In 2008, Lehman Brothers filed for bankruptcy, causing bondholders to lose significant portions of their investments. Investors in corporate bonds from other struggling financial institutions also faced heightened default risks during the financial crisis.
5. Liquidity Risk: Some investments are not easily sold or converted to cash without taking a significant loss. Real estate and certain small-cap stocks are examples of assets that could carry liquidity risk. Example: If you own a commercial property and need to sell it quickly due to a financial emergency, you might have to accept a much lower price than its market value because finding a buyer quickly is challenging. Similarly, small-cap stocks with low trading volumes might require you to sell at a steep discount.
6. Currency Risk: If you invest in foreign assets, changes in exchange rates can affect the value of your investments. Even if the foreign asset performs well, an unfavorable exchange rate could reduce your returns. Example: Suppose you invest in a European stock that performs well, yielding a 10% return in euros. However, if the euro weakens against the dollar by 15% during the same period, your investment will show a net loss when converted back to dollars.

Understanding the types of risk you’re exposed to is the first step in building a solid investment strategy.

Diversification: Your Best Friend in Risk Management

One of the most effective ways to manage risk is through diversification. Simply put, diversification means spreading your investments across different asset classes, industries, or geographic regions. The goal is to reduce the impact of any one poorly performing investment on your overall portfolio.

For example, imagine you’ve invested all your money in tech stocks. If the tech sector experiences a downturn, your entire portfolio will suffer. But if you’ve diversified—spreading your investments across tech, healthcare, utilities, and bonds—your losses in one sector may be offset by gains in another.

It would be nice to have only that one asset that outperformance all the others, but that's an incredible hard task and most who achieve it is only based on luck and carrying and huge amount of risk. On the other hand, that one asset you chose could be the one who underperforms all the others.

That's where diversification plays the most important role in investing, the role of protecting the capital against the unknowns about the future. If your portfolio loses 10%, it would need a gain of 11% to breakeven, that is not so much difference. Now, for a loss of 70%, the same portfolio would need a gain of 233%, that is a big difference.

Diversification across assets, sectors and classes protects your portfolio from this risk, although it does not eliminate the risk completely.

Here’s why diversification works:

• Reduces exposure to individual investment risk: No single investment will make or break your portfolio.
• Smooths out returns: While diversification doesn’t eliminate risk, it can help moderate the highs and lows of your portfolio, leading to more stable returns over time.
• Allows for balanced growth: You can achieve a mix of high-risk, high-return investments with safer, more stable assets.

Remember, diversification isn’t just about having more investments; it’s about having the right mix of investments.

A example of a generic diversified portfolio would be something like this:

Stocks (60%)

• Domestic Large-Cap Stocks (30%): S&P 500 index fund or large, stable companies like Apple, Microsoft. These provide growth and relative stability.
• Domestic Small-Cap Stocks (10%): Small-cap ETF or individual smaller companies with high growth potential but more volatility.
• International Stocks (15%): Developed markets (Europe, Japan) and emerging markets (China, India) for geographic diversification.
• Sector-Specific Stocks (5%): Technology or healthcare ETFs for exposure to high-growth industries.

Bonds (30%)

• Government Bonds (20%): U.S. Treasury bonds or Treasury Inflation-Protected Securities (TIPS) for stability and income.
• Corporate Bonds (10%): Investment-grade corporate bonds for slightly higher yield and moderate risk

Real Assets (5%)

• Real Estate (5%): Real Estate Investment Trusts (REITs) for exposure to real estate without direct property ownership.

Commodities (3%)

• Gold or Other Commodities (3%): Gold ETFs or other commodity funds to hedge against inflation and market uncertainty.

Cash and Cash Equivalents (2%)

• High-Yield Savings or Money Market Funds (2%): Provides liquidity and a cushion for emergencies or short-term opportunities.

Why This Portfolio is Diversified

1. Asset Class Diversification: Spreads risk across stocks, bonds, real estate, commodities, and cash.
2. Geographic Diversification: Includes both domestic and international investments to mitigate risks tied to any one region.
3. Sector Diversification: Allocates within equities to large-cap, small-cap, and specific growth sectors.
4. Risk Management: Bonds and cash provide stability, balancing the volatility of equities and commodities.

Remember: This portfolio allocation does not constitute investment recommendation, please do your own analysis or consult with a professional,

Balancing Safety and Growth

Every investor faces a fundamental dilemma: How much risk should you take in pursuit of higher returns?

If you’re too conservative, you might miss out on growth opportunities that could significantly increase your wealth over time. On the flip side, if you take on too much risk, you could experience sharp losses, which can be financially and emotionally draining.

The key to success is finding the right balance between safety and growth. This balance is influenced by your risk tolerance, investment goals, and time horizon. A well-constructed portfolio should reflect this balance, combining elements of both risk and stability.

• For younger investors, a higher allocation to stocks can help drive long-term growth, with time to recover from any downturns.
• For older investors or those nearing their financial goals, a more conservative approach, with greater exposure to bonds or other safer assets, may be appropriate to preserve capital.

The Art of Balancing Risk and Return

Mastering the concept of risk and return is essential for anyone serious about building wealth. While risk is often viewed negatively, it’s the very thing that allows us to earn returns on our investments. The key is to take the right amount of risk. Understanding that uncertainty is an inherent part of investing.

Next, we’ll dive into the different investment vehicles and asset classes you can use to craft a diversified and well-balanced portfolio. These tools will help you align your strategy with your risk tolerance and financial goals, setting the stage for long-term success.

Investing Pillars Part 2: Investment Vehicles and Asset Classes >>>