Weighing up risk and return

Risk is an interesting topic.  In life, we take risks every day.  Some are very small – like trying a new product, some larger – such as smoking or gambling your life savings.  Each time we take a risk, we are hopeful the payoff will make it all worthwhile.

Instinctively, we weigh up the potential gain with the possible loss and make our decision.  This process happens every time no matter whether you are a risk taker or not.

Like beauty, risk is in the eye of the beholder.  What one person may perceive to be risky behaviour could be quite different to another.  How people make this assessment will vary on the individual and how they use the information available to them.

In finance and investment, we tend to think of risk as the chance of us losing our money, whatever that may be.  Mathematically, risk is measured in standard deviations around an average expected return.  In plain English, a larger standard deviation means higher volatility (and greater risk) than a lower, more predictable one.

Let me illustrate with a simple example.  Both Investment A and Investment B average a 4% return over 3 years.

Investment A returned 5% in the first year, 4% in the second year and 3% in the third year (4% + 5% + 3%) ÷ 3 = 4%.

Investment B, on the other hand, returned 10%, -7% and 9% over the same timeframe. (10% – 7% + 9%) ÷ 3 = 4%.

Although the two investments averaged the same return, Investment B has clearly been riskier over this period.

Obviously hindsight is brilliant in this case but the point to learn here is that you don’t always need to take a large risk to earn the same return.

All investment decisions should be made with a risk free reference point in mind to give the decision some context.

For any of us, the closest thing to a risk free investment is bank interest.  Ask yourself this: If a bank can offer say, 4% with near zero risk, what sort of return should I be expecting to earn on another investment that does contain risk?  If your alternative is only offering a marginally higher return, is it worth the risk – particularly when borrowing large sums of money?

There is no clear answer to this as each case is different.  My tip is to take a step back and do your homework before rushing in.

Daniel Budreika
Planning for Prosperity

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