Investing Basics: The Risk-Return Tradeoff

Investing Basics: The Risk-Return Tradeoff
Eileen St. Pierre, The Everyday Financial Planner

When it comes to investing, most people want the conversation to immediately turn to where to put their money. Sorry to burst your bubble, but the conversation needs to start at a much more basic level. You first need to understand the tradeoff between risk and return.

RiskThere is a positive relationship between risk and expected return.

This sentence may seem like a no-brainer, but you would be surprised at how few people understand it. Let’s say I have a choice between two assets:

  • Certificate of Deposit (CD) insured by the FDIC
  • S&P 500 index fund.

The index fund is considered riskier than the CD. It is not insured by the FDIC. The value of the underlying asset, the S&P 500 index, fluctuates on a daily basis. In order for me to invest in the index fund instead of the CD, I expect to earn a higher return to compensate me for this extra risk. I then need to decide if this investment is worth the extra risk.

My actual return in a given time period may differ from my expected return.

This is when I start seeing the “deer in the headlights” looks from people. Suppose I expect to earn an 8% return on my index fund over the long-term. My actual return may differ from 8%. Here’s an example:

  • In Year 1, my actual return was 5%.
  • Year 2 was a great year – I made 20%!
  • But in Year 3, I lost 1%.
  • If I held this investment for these three years, I will have averaged 8% a year.

The riskier the asset, the more my actual return will deviate from my expected return.

You can see from this example how my actual return fluctuates. We quantify risk by how much the actual return deviates from the expected return. There is more deviation with the index fund than with the CD. This deviation can be a real benefit, like in Year 2 when I earned 20%. But it can also hurt, like in Year 3 when I lost 1%.

  • Which year would you remember the most?
  • If you are really averse to risk, you will probably remember Year 3 the most.
  • Someone who is a bit more risk tolerant will probably remember Year 2 the most.
  • Would you be able to handle the fluctuations in actual returns? If not, then this investment is too risky for you.

Here’s the bottom line.

Each investor is unique. You need to determine your own tolerance for risk. This tolerance will also depend on your investment goal and related time horizon. If I am investing for a down payment on a new house, I would have a lower risk tolerance than investing for retirement because my time horizon is much shorter. While I would be more willing to put my retirement money in stocks, I would keep my new house fund invested in safer assets since I would have less time to recoup losses.