Risk vs reward with investments

June 20th, 2016 by

The following two tabs change content below.
Dan Woodruff

Dan Woodruff

Certified Financial Planner & Chartered Wealth Manager at Woodruff Financial Planning
Financial Planning helps you to navigate and anticipate significant life changes. I want to help you to ensure your money is managed wisely to give you the financial security that will fund the future and lifestyle that is important to you.
Risk vs reward with investments

Risk vs reward with investments

Have you ever wondered what is the point of taking risks with investments? In this article, we examine the benefits and risks of investing: the trade off that is risk vs reward with investments. We show you the benefits of taking extra risk using data and examples, but also highlight the downsides.

Key points:

  • The nature of risk vs reward with investments
  • What’s the point in taking risk?
  • Data on risk vs reward with investments
  • How extra risk can generate additional returns
  • How to decide what risk to take with your investments

The nature of risk vs reward with investments

Generally, the greater risks you are prepared to take, the greater returns you should expect, on average, over time. The reverse should also be true: the lower the risks you are prepared to take, the lower the returns you should expect, on average over time.

Let’s break this concept down, and explain it.

Risks

By risks we mean 2 things. Firstly, the risk of getting back less than you invested, or losing money. We also mean the volatility of your investments – how much the investments fluctuate in value over any given period. Volatility is easy to measure; the higher the volatility, the more your investments fluctuate in value. This means that higher risk investments change value faster and more wildly. This does not mean that they grow less.

Generally, we would see a bank account as a low risk and low volatility investment. Bank accounts represent the slow and steady approach, with effectively no risk unless the institution fails. Shares might be a high risk and high volatility investment. Shares tend to fluctuate lot more than bank accounts depending on the economic conditions and sentiment of the market.

Returns

Returns essentially means growth, including income. Logically, you would look for the highest returning investment possible. Typically, a bank account might be seen as a low-returning investment; shares might be seen as a high-returning investment.

On average, over time

Investment conditions vary from day to day and year to year. Therefore, we can only look backwards to examine what has typically happened in the past, and use this as a base for our assumptions for the future. Low risk investments like bank accounts tend to generate low returns on average, over time. Higher risk investments like shares tend to generate higher returns on average, over time. Unfortunately, the ideal investment with low risks and high returns does not exist. Be wary of anyone who tells you any differently!

Time is very important in this calculation. The longer you invest for, the less likely you are to lose money in the long run. The general trend is upwards (on average) for all types of investments, given a long enough time scale. You can be more certain of outcomes with a low risk investment than you can with a high risk investment, simply because low risk investments fluctuate in value less. You can also be pretty sure that you will generate less return for your money in a low risk investment, and you can be more sure of this the longer the period over which you invest.

Time and your ability to bear losses

Think about how long you can let your money grow before you need to access it. When you do access the money, will you need all of it, or can you leave the rest to grow? If your timescale is short (less than 5 years), then you should probably look for no risk. Imagine you have been given an inheritance of £200,000 and you plan to use this money to buy a property in the near future. You could decide that you are prepared to take a risk with your money to aim to grow it and buy a larger property. How would you feel if that money went down in the short term and you had to buy a smaller property? This describes your ability to bear losses, and is an important factor in your decision whether to take risks.

Let’s say that you are planning for retirement in 20 years. Any short term losses, even with riskier investments, have a much better chance of being overcome the longer you are prepared to invest. In this case, you are more likely to choose a riskier investment in the anticipation that this will generate superior results over time than a low risk investment.

Risk appetite is not logical

On the face of it, you would think that the risk vs reward calculation is simple. On paper, take less risk with shorter term investments, and greater risks with longer term investments. In theory, greater risks lead to greater rewards. However, your experience and knowledge (or lack of it) might tell you differently. If you experience losses, these tend to stay with you for longer than the boost that comes from growth on your money. Logic may dictate that the market should recover, but fear might make you worry that it will not. This is why many amateur investors take less risk than they should.

Important

Investing is a complicated subject and you should be aware that your money can go down as well as up. There are rarely any guarantees with investments. Even bank accounts can lose money, although this is far less likely than with other, riskier investments. Seek professional investment advice before you embark on any investment plans.

What’s the point in taking risk?

Risk vs return is a trade-off

You should only take additional risks if you can expect a corresponding additional return for that risk; otherwise, there’s no point in taking that extra risk. The difficulty for an amateur investor is to measure risk vs returns with investments.

You might not have thought about this in the past, but your ability to take risks can have a massive impact on your future security and lifestyle. If the average return for the risks you take turns out to be true (there’s no guarantee of this), then your ability to spend in the future should be greater with a riskier approach than with a cautious approach. There is more likelihood of variation with a riskier approach, although the longer the period over which you invest, the more likely you should generate a profit. This does not mean that you should take extra risks, but you should consider whether this is appropriate for your position.

Financial planning and risk

The traditional financial adviser will discuss the nature of risks with you and probably will get you to complete a risk questionnaire to explore your attitude to risks in a number of areas. This is an important way of measuring your experience and attitudes, and helps the financial adviser to recommend an appropriate investment strategy for you. However, this approach is flawed. I see this as the equivalent of sticking a pin in your arm and working how far you can push before you say “ouch”.

A Financial Planner will take a different approach. While it is important to know the upper limits of the risks you can take, you should also examine how much risk you need to take to achieve your goals. This is where a financial plan can help with the examination of risks. Your risk profile might be cautious. But if your financial plan highlights the need to take moderate risks to achieve your financial goals then you may need to reassess your attitude towards risks, or alternatively reduce your lifestyle expectations.

Data on risk vs returns with investments

We have examined different investment approaches, using past data, to show you the impact and benefits of taking additional risks. This should help you to better understand the trade-off between risks and returns.

Risk vs reward chart over 5 years

The chart below shows the relationship between risks vs returns with investments.

risk v reward 5 years 500

Source: Financial Express

How to read this chart

The left-hand axis shows annualised performance (growth) over 5 years, which shows the return each year required to get to the cumulative growth shown over the same period. The higher up an asset appears, the greater the annualised performance.

The bottom axis shows annualised volatility, which measures the fluctuations in the asset values over the period. The more to the right on this axis, the more volatile an asset is, and therefore the riskier its approach.

Effectively, this chart shows the relationship between risk vs rewards with investments, since it demonstrates that as assets take more risk (they move to the right), so they tend to generate greater returns (move up). If these assets move to the right but do not move up on the chart then this shows no reason to take the additional risk.

Data used in this risk vs reward chart

We have plotted the following:

  • A – our Adventurous risk model portfolio
  • B – our Moderate risk model portfolio
  • C – our Cautious risk model portfolio
  • D – the average return for a UK shares unit trust
  • E – a sample bank account

You can see from this risk vs reward chart that the lowest risk and lowest returning asset is the bank account. From this data you can see that you should expect low returns over time (which may lose money versus inflation).

The riskiest asset was the average UK share fund, but this investment appears to have under-performed versus other strategies.

The model portfolios each prove the expectation that the additional risk taken each time generated additional returns:

  • The Cautious model portfolio was riskier than the bank account but generated additional returns, thus justifying the risks taken
  • The Moderate model portfolio was riskier than the bank account and Cautious model portfolio but generated additional returns, thus justifying the risks taken
  • The Adventurous model portfolio was riskier than the bank account, Cautious and Moderate model portfolios but generated additional returns, thus justifying the risks taken
  • Interestingly, the average UK shares fund was riskier than the others, but returned less than all of the model portfolios. This shows why it can be dangerous to rely solely on past performance data, and also the benefits of diversification with assets. The model portfolios each invested in a variety of other investment types, which probably accounted for the superior returns over the period shown.

How extra risk can generate additional returns

This chart shows the effect of investing £10,000 in each of the strategies over the 5 year period. This shows that in these examples, the result of taking additional risks was overall additional returns.

risk vs reward 5 years growth 500

You can see from the above that each of the assets fluctuates over time, but that the time invested widened the overall results. Just remember that this is not always the case, especially in particularly volatile markets.

How to decide what risk to take with your investments

The simplest way to be sure you are striking right balance between risk vs reward with your investments is to take advice from an investment professional. You can also download our in-depth investment guide, below, which will give you more insight into the risks you take with investments.

Tags: , , , ,

Comments are closed.