The Risk / Return Trade-Off Principle
When it comes to investing and financial management, sometimes understanding the fundamentals is all people require to become effective managers of money; lay the foundations, and you can begin to build your wealth. However, research shows that we aren’t always as aware of the foundations as maybe we should be. Between September 2015 and February 2016, the Australian Securities and Investments Commission conducted a study on Australian Financial Attitudes and Financial Literacy. The following statistics were reported for understanding of the risk/return trade-off investing principle:
Whilst the results may be surprising to some, we thought that the best way to educate 67% of Australians on fundamental financial literacy was – quite simply – to tell them in a way that is simple and easy to understand. As such, welcome to MW Lomax Investment Lessons 101: The Risk/Return Trade Off.
Whether you are making an investment in shares on the stock market, real estate, government bonds or any other financial instrument, there are two factors your investment is guaranteed to have; risk and return. Quite simply, risk refers to the probability or likelihood of losses relative to your investment. No investment exists that is completely risk free. Whilst risk refers to the probability or likelihood of losses, return measures the actual gain or loss your investment generates. Whilst the word return is most commonly associated with a gain, it is perfectly possible to have a negative return, obviously indicating an actual loss on your investment. The risk/return tradeoff is therefore an investment principle that indicates a correlated relationship between these two investment factors.
The tradeoff, conceptualised by the graph above, is quite simple: investments with higher risk are associated with greater probability of higher return, whilst investments with lower risk have a greater probability of smaller return. For example, if Bob decides to buy shares in Company X which operates in a high risk market (which high risk can be influenced by a broad range of factors), he has a greater chance of the investment producing a loss. However, if Company X were to achieve a profit, Bob’s return and monetary gains would stand to be comparatively much higher than an investment in, for example, Company Z, which operates in a market characterised by low-risk and posting continuously stable yet low returns. In a high risk investment, Bob stands to both gain and lose more, than a low risk investment.
Simply because an investment is high risk, that does not mean it is not worth pursuing. There are a range of reasons why people pursue both high and low risk investments, and many seasoned investors will seek to leverage high risk investments with low risk investments, in order to diversify their portfolio by providing the opportunities for high returns, without sacrificing their entire investment value. However, fundamental understanding of the risk/return tradeoff will allow investors to make better decisions regarding their investment choices, given their personal investment goals and desires.