Chapter 3. Understanding Risk and Return
Understanding Risk and Return
Risk and return are two closely intertwined concepts, as investors who are seeking higher returns must be willing to take on greater levels of risk, whereas those who prioritise preserving capital must accept lower returns. In this chapter, we will delve into the relationship between risk and return, explore the different types of investment risks, and discuss strategies for balancing risk with the potential for returns in your portfolio.
Definition of Risk and Return
Risk: Risk refers to losing some or all of the original amount invested in an asset, and it acts as a measure of the uncertainty or volatility associated with an investment.
Return: Return is the profit or gain generated by an investment, often measured over a specific period, and can be expressed as a percentage of the initial investment.
Types of Investment Risks
There is more than one type of risk that you face when investing in financial markets, with four of the most common risks outlined below:
Market risk: This is the risk that the overall market will decline, affecting the value of an investment. Market risk is inherent in all investments and cannot be diversified away.
Credit risk: This is the risk that a borrower will default on their debt obligations, and it is particularly relevant for bond investors.
Liquidity risk: This is the risk that an investor will be unable to sell their investment quickly enough or at a fair price. Liquidity risk is often associated with illiquid assets like real estate or private equity.
Operational risk: This is the risk that a company's internal processes and systems will fail, resulting in financial losses. Investors who hold individual companies are often most concerned about operational risk.
Balancing Risk and Return
When building an investment portfolio, you must carefully consider the balance between a desire for returns and your risk tolerance. However, there are a number of strategies to help find this balance:
Diversification: By spreading investments across different sectors, geographic regions, and types, investors can reduce their exposure to any particular asset’s risk.
Asset allocation: Similar to diversification, this involves dividing a portfolio among different asset classes, such as stocks, bonds, and real estate, to achieve an optimal balance of risk and return.
Risk-adjusted returns: When building a portfolio, you should focus on achieving returns that are adjusted for the level of risk taken. Therefore, investments deemed higher risk should offer higher potential returns to compensate for this.
Key Takeaway
Having an initial understanding of the relationship between risk and return is crucial for building your investment strategy. By recognising the different types of investment risk and implementing strategies to balance risk and potential returns, you can make more informed investment decisions and have a better chance of achieving your financial goals.
In the next chapter, we will explore the various asset classes and investment vehicles available to investors and discuss their characteristics, benefits, and risks.