In terms of investing, What is the relationship among return and risk? It will be easier to make investment decisions if you understand the relationship between return on investing and risk.
We know that there is a variety of asset classes like gold, bonds, and stocks. Knowing how to make these assets more profitable and less risky is key. Because this will make it easier to adjust the target investment and investment process.
Economists have a habit of saying that there is no free meal. In other words, high returns on investment come with significant risk. A safe investment, however, comes with low return. This is called the risk/return ratio.
How do you balance risk and return?
Diversifying your portfolio also means you can combine multiple investment instruments to achieve your goals. Which investment mix is best for you? The two most influential factors in investment are Return (or risk)
Return, or yield, refers to the expected return of the money you invest. Risk refers to the possibility of a different return than what was expected. In other words: risk is the degree of volatility associated to an investment.
Four main asset types
- Equity: One type of investment, which can be described as ownership in a business or shares.
- Bonds: Investments like debt. A bond is a type of loan that you make to a company or government. You will receive interest as a return. In addition to the initial capital, interest will be paid at the end.
- Alternative Investments include property, commodities, and gold. This asset class may be more risky that equities and bonds. However, expected return patterns and trends are different than for bonds and equities. This asset type is suitable for diversification.
- Cash: That’s right, cash. Cash is an asset class. However, cash can also be a liquid, short term investment. Banks offer easy access to short-term cash deposits.
Why is this risk-return pair so important?
Investors are willing and able to take on more risk in order to receive a higher expected return. A portfolio investor looking to improve its profitability should accept greater risk.
Each investor is more “risk-phobic” and each investor has his or her own perception of the “optimal risk / return balance.
The amount saved also influences the risk behavior. A large amount of savings can lead to the investor putting a significant amount into risky investments. However, investments that yield low returns but are safe are better if savings are low.
On the financial market, bonds issued by certain nations that have been deemed safe (e.g., France, Germany) are the least risky. They are used to finance the public debt of these countries.
Volatility
Volatility plays an important role in assessing risk.
Volatility measures the changes in prices of financial securities such as bonds, currencies, stocks and currencies. The more volatile a stock will be, the more sensitive it’s price to news or bad news about the company. High volatility refers to the fact that the price fluctuates greatly and thus, the risk associated the value is higher. Stock prices are much more volatile that bonds. Statistical studies have shown that stock volatility decreases with time. So, the risk of stock volatility is lower if you hold stocks for a longer time.
The risk premium
It is the gap between the yield on government bonds and those on riskier investments like stocks or corporate bonds. In other words it is the additional remuneration the investor is offered in order to agree to buy these bonds and these shares rather then subscribe to government bond. Bond yields can be compared directly with government bond yields. Because of the higher risk of default, it is always higher.
An investor may sell his bond before it matures, but the interest rate evolution will influence the price. Since it provides a lower yield, bonds with higher rates will lose their value before they reach maturity.
It is generally believed that equities perform better long-term than bonds due to the higher risk they present.
The more difficult the company is, the more doubts there are about its ability to pay its loans (bonds), and to generate profits. Therefore, its shares will be less valuable as well as the bonds they issue. .
A historical analysis of stock return in the United States shows a real, and more or less valid, trend towards e. Annual inflation-adjusted return of stock returns in the United States, including between 6.5% – 7%. This is more than the yield for long-term government bonds (1.7%). The risk premium is the difference at 4.9 points.
This study compares nearly two centuries of annual returns on stocks (XIX th) and bonds (XX _ th), and shows that there is a larger gap between the best performance stock and the worst than the gap between bond yields. This would indicate that equities offer more potential for profit and greater risk than bonds.
The paradox of actions
Multiple studies have demonstrated that stock are not more risky than bonds but offer a better return.
It is a simple principle: The good years will compensate for the bad. Stocks will not be as risky as bonds over the long term and might be suitable even for the most cautious investors. While the risk of a market collapse could explain the better return on equities’, there is no denying that bonds are more profitable than equities.
Stocks aren’t more risky than other investments, even though they offer a greater return over time. However, it is essential to safeguard against bad performance in the short term. Diversifying your portfolio is the best thing. portfolio . This will lower both the risk and the expected return. However, it will allow you to position higher in terms returns while still maintaining your “level of risk absorption”.
The duration of the placement
Many studies (from to INSEE), show that the odds of making an investment increase with time. Also, that the period of investment increases the chance of making a loss and that the longer the period of investment reduces the risk. loss, but this lengthening may also reduce the chances for a particularly high peak win.
As solid as these findings might seem, it is important to remember that they are based upon past statistics over long and medium periods. These do not permit us to project future performance.
Ideal Investment Portfolio
The best portfolios will have a balanced return-risk ratio.
Imagine that you plan to buy a home within 3 years. You don’t want risky investments and you also plan to save your money. You want your savings to be there when you have the money to pay the downpayment.
Thus, you can optimize security while also maximizing returns. Your portfolio may be more likely to be invested in bonds that have low risk and cash rather than equity.
However, if your goal is to reach it in 10 years, then you might not have any problems with current risk.
For maximum returns, you may want to allocate more equity than bonds and cash to your portfolio.
Understand the risks and return on investment. Like any other valuable item, you need to be aware of the risks.