1.6 Risk and Return in Financial Markets

The relationship between risk and return is a fundamental principle in finance. The expected return on an investment is directly correlated with the level of risk. While the return on an investment is the money earned or lost, the risk of the investment is the uncertainty surrounding the potential outcome. How do you know before the fact if an investment will do well or poorly? The short answer is, you don’t. In hindsight, you will know the optimal investment strategy, but the future is uncertain. You can use historical data to build out expectations for the future, but the outcome will remain uncertain. How much risk are you willing, and able, to take on?

Risk Tolerance

Your ability to take on investment risk is a function of objective measures, such as wealth, financial goals, investment time horizon, and need for liquidity. You have probably wondered how the rich keep getting richer, while the poor seem to be getting poorer. Well, this is primarily a function of people with plenty of discretionary income being in a position financially to invest in higher-risk and higher-reward ventures. People who are often struggling to cover non-discretionary expenses or “make ends meet” are oftentimes living paycheck to paycheck and are either not investing at all or are investing in safe products such as deposit savings accounts. While completely rational, this makes it difficult for those with lower income to accumulate assets, such as stocks, and not liabilities, such as car and house payments. Research has shown that wealthier individuals are more likely to earn higher risk-adjusted returns on investments.

Your willingness to take on investment risk is mostly psychological once basic needs are met. Suppose you have the choice between getting $5,000 with certainty or having a 50% chance of getting $15,000 or nothing (a coin flip). Did you choose the $5,000? If so, you are not alone. Many people are referred to as risk averse, which means they will choose certain outcomes over uncertain outcomes, even if the latter has higher risk-adjusted value. In the example above, the decision to flip the coin produces a risk-adjusted return of $7,500 [(50% × $15,000) + (50% × $0)], which exceeds the certain return of $5,000. The decision to play the game or not play the game is primarily determined by your tolerance for risk. Identifying your risk tolerance level will help you strategically allocate your money across assets. If you are losing sleep over an investment, then it is probably not the investment for you.

Performance of Financial Assets

The easiest way to observe the risk and return trade-off is to compare the historical performances of different financial assets. Debt securities, such as bonds, are often less risky than stocks because their cash flows are more certain. With a bond investment you often receive regular cash inflows from interest payments, plus you are guaranteed your money back at the end. In contrast, with a stock investment you are not guaranteed any payment, and the performance of your investment is tied entirely to the productivity of the company. The following table outlines the returns for various bond and stock investments over a 50-year period (1972 to 2021).

The average rate of inflation is a good starting benchmark, as you want to produce a real return when investing, which is the difference between the investment return and the rate of inflation. Inflation can be thought of as the decline in the purchasing power of your money over time. An increase in inflation means that the costs of goods and services (e.g., gas and groceries) around you increase, making the money you have in your pocket less valuable. The average annual rate of inflation over the sample period is 3.95%. A short-term (3-month) government bond is considered to be one of the safest investments, as it is unlikely that the U.S. federal government will not be able to pay its debts in the short run. A long-term (10-year) government bond is slightly riskier, since economic conditions can change dramatically over a longer time horizon, making it more difficult for the federal government to pay off its debts. The average annual rates of return on short- and long-term government bonds over the sample period are 4.44% and 6.10%, respectively. Not all corporations are created equal—some are riskier to invest in than others. There are rating agencies, such as Standard & Poor’s, Moody’s, and Fitch, that grade corporations on their ability to pay back debts (more on these agencies later). The average annual returns for low- and medium-risk corporate bonds are 7.25% and 8.33%, respectively. The riskiest investment among these alternatives is stocks, and the average annual return on large company stocks over the sample period is 12.58%.