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- What's more important; risk or return?
What's more important; risk or return?
- By Dirk Dobbs
- Published 4/09/2008
- Winter 2008
- Unrated
This is the first of a series of two articles on the interaction of risk and return. This article will focus on trying to define what risk and return actually mean and how they interact to deliver performance. The next article will focus on what or why ‘good risks should be included in a portfolio and what or why ‘bad risks should be avoided.
What's more important; risk or return? One without the other just doesn't make sense because they go together like honey and a bee.
Return is relatively easy to understand. Put simply, it is the gain you earn from an investment, and can be in the form of either income (interest, dividends, rent etc), capital appreciation (increase in value of the initial principal invested), or most commonly a combination of both – total return. As we all know, rates of return vary depending on the type of asset (eg shares, cash etc), with shares generally providing higher returns than cash. But why is this? Essentially, it all comes down to risk, i.e. what risks have been taken to provide a certain level of return.
Risk is far more complex to understand, as it has many connotations and means different things for different people. For instance; risk of low/no return, risk of capital loss, the risk that goals and objectives are not achieved etc. The Chinese symbols for risk (see below) give an interesting and what I believe is a very accurate description of risk.
The first symbol is the symbol for 'danger', while the second is the symbol for 'opportunity', making risk a combination of dangerous opportunity‘. More commonly, risk is defined as volatility (or the variability) of returns; the size of the ups and downs in the value of an asset.
So let's try and understand what risk, or volatility, really means, and how it affects investments.
As an investor, you expect a return (as defined above) on any investments you make. It's reasonable to expect a cash investment will provide you guaranteed, risk free interest payments and your capital back when you want it.
However, you recognise that when investing in shares, there is no guarantee of regular dividends and definitely no guarantee on whether you will get back the original sum invested when you want it. This is because the performance of shares are dependent on a large number of external factors that can affect the return generated, eg management, demand for product/service etc.
Due to the multitude of external factors affecting the performance of shares, they can go in and out of favor with investors, causing their value to rise and fall very quickly and sometimes by a significant amount. This movement attributable to shares is their risk or volatility. To compensate you for taking on this additional risk of potentially significant up and down movement, it is also reasonable to expect a higher rate of return from shares.
Importantly, the higher the rate of return expected, the higher the relate level of risk that needs to be accepted to achieve that return. This relationship is best explained by the following diagram. As you try to achieve ever higher rates of return (A >B>C), the risk you have to accept increases at a much faster rate (D>E >F). What this means is that as the curve begins to flatten (between points 2 – 3), additional risk will not result in the same amount of additional return.
The other important thing to realise is that risk is not a bad thing; without any risk your portfolio would produce ordinary returns. That is, if your worst case scenario is that you are not willing to accept a rate of return below the prevailing cash rate (around 8.5 per cent at the moment) because you are not willing to take on any share market risk, then you must also realise that the cash rate is your best case scenario 1 – you cannot expect a 10 per cent return by placing your capital into a bank account paying only 8.5 per cent?
As you can see, risk and return can be difficult concepts to comprehend. But once you understand that you cannot get a return without taking on some risk, you have set yourself on the path to enjoy a successful long term investment experience.
In the second article in this series we will explore the difference between good and bad risks and how these can be included (or excluded) when constructing a portfolio. In the mean time, as Warren Buffett says, “Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.”
Dirk Dobbs
What's more important; risk or return? One without the other just doesn't make sense because they go together like honey and a bee.
Return is relatively easy to understand. Put simply, it is the gain you earn from an investment, and can be in the form of either income (interest, dividends, rent etc), capital appreciation (increase in value of the initial principal invested), or most commonly a combination of both – total return. As we all know, rates of return vary depending on the type of asset (eg shares, cash etc), with shares generally providing higher returns than cash. But why is this? Essentially, it all comes down to risk, i.e. what risks have been taken to provide a certain level of return.
Risk is far more complex to understand, as it has many connotations and means different things for different people. For instance; risk of low/no return, risk of capital loss, the risk that goals and objectives are not achieved etc. The Chinese symbols for risk (see below) give an interesting and what I believe is a very accurate description of risk.
 |
So let's try and understand what risk, or volatility, really means, and how it affects investments.
As an investor, you expect a return (as defined above) on any investments you make. It's reasonable to expect a cash investment will provide you guaranteed, risk free interest payments and your capital back when you want it.
However, you recognise that when investing in shares, there is no guarantee of regular dividends and definitely no guarantee on whether you will get back the original sum invested when you want it. This is because the performance of shares are dependent on a large number of external factors that can affect the return generated, eg management, demand for product/service etc.
Due to the multitude of external factors affecting the performance of shares, they can go in and out of favor with investors, causing their value to rise and fall very quickly and sometimes by a significant amount. This movement attributable to shares is their risk or volatility. To compensate you for taking on this additional risk of potentially significant up and down movement, it is also reasonable to expect a higher rate of return from shares.
Importantly, the higher the rate of return expected, the higher the relate level of risk that needs to be accepted to achieve that return. This relationship is best explained by the following diagram. As you try to achieve ever higher rates of return (A >B>C), the risk you have to accept increases at a much faster rate (D>E >F). What this means is that as the curve begins to flatten (between points 2 – 3), additional risk will not result in the same amount of additional return.
 |
The other important thing to realise is that risk is not a bad thing; without any risk your portfolio would produce ordinary returns. That is, if your worst case scenario is that you are not willing to accept a rate of return below the prevailing cash rate (around 8.5 per cent at the moment) because you are not willing to take on any share market risk, then you must also realise that the cash rate is your best case scenario 1 – you cannot expect a 10 per cent return by placing your capital into a bank account paying only 8.5 per cent?
As you can see, risk and return can be difficult concepts to comprehend. But once you understand that you cannot get a return without taking on some risk, you have set yourself on the path to enjoy a successful long term investment experience.
 |
In the second article in this series we will explore the difference between good and bad risks and how these can be included (or excluded) when constructing a portfolio. In the mean time, as Warren Buffett says, “Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.”
Dirk Dobbs
Manager
ddobbs@moorestephens.com.au
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Article Series
This article is part 1 of a 2 part series. Other articles in this series are shown below:
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What's more important; risk or return?