What is the Correlation Between Risk and Return?

Answer...

One of the more basic relationships in investing is that between risk and reward. Investments that offer potentially high returns are accompanied by higher risk factors. It is up to you to decide how much risk you can assume. Always keep in mind your current and future needs.

There are many types of risk. The one most people think of is market risk, which is the risk that market prices can fluctuate. If you have a short investment horizon, generally something less than five years, this risk is important since the market could be down at the time you most need the money. On the other hand, if you have a long time horizon, for example when saving for retirement, you may be unconcerned with market risk. The investment has the opportunity to come back prior to the time you need the funds.

Another risk, which many people don’t think about, is purchasing power risk. This is the risk that your investment will not keep up with inflation and you will not be able to maintain your desired standard of living. A bank CD for example might pay interest of 3% and have no market risk. Your principal does not fluctuate in value and you are insured against loss. However, if inflation exceeds 3% you will lose purchasing power.

TIP 1: In general, prospective investors should avoid "risky" investments unless they have a steady income, adequate insurance, and an emergency fund of readily accessible cash.

TIP 2: U.S. Treasury bills, notes, and bonds are the safest possible investments.

You need to assess how much risk you can tolerate. One easy way to measure this is how well do you sleep at night. If you lie awake worrying about your investments, you risk tolerance is probably too low for your current investment strategy. In general the longer your investment horizon the greater the amount of risk you can afford to take. Your financial advisor can also assist you in measuring your risk tolerance.

Risk can also be reduced through diversification. Rather than buying one stock, buy a basket of 20 to 30 stocks. This reduces your overall risk. You can also reduce risk by combining different investment types such as stocks, corporate bonds and government bonds. These securities are not highly correlated (i.e. they tend not to go up or down at the same time).

Why would one want to take on more risk? Because it generally comes with a higher expected return. While stocks may have the greatest market risk, they have also provide that highest market return over the long haul. Stock returns have averaged between 10 and 11% since the early part of this century. Corporate bonds on the other hand have averaged between 6 and 7% and government bonds closer to 5%. As you can see the lower the risk the lower the expected return. You must balance the amount of risk you are willing to tolerate with the amount of return you expect to achieve. There is no such thing as a high return/low risk investment.

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