Investment Risk – What is it?

Question – I regularly hear the comment “The higher the investment risk, the greater the investment returns.” Can you help to explain risk and returns? 

Answer – It is very common to hear investment advisors talking of risk and return and generally the line is the greater the risk, the greater the potential return.

Firstly, let’s look at ‘low’ investment risk

Most advisors would agree that the safest investment is a government bond. For example, a 10 year US Treasury bond.

The government bond will pay a fixed interest rate (often referred to as the coupon rate). Both the interest payments and the return of your capital at the end of the term (10 years), are guaranteed by the government.

There are two key risks with a government bond

1. Will the Government pay the interest and Payback the Capital?

Governments have been known to ‘default’ on their bonds, that is to say, not pay back what they promised. At the time of writing (Sep, 2011) this is a growing concern with some economist expecting a small number of countries to default on their bonds. For example, Greece is highlighted as a country who may well default on their bonds.

2. Losing Value if you Trade (Sell) the Government Bond 

The sale price (capital value of your bond), may not be worth what you paid for it if you sell before maturity.

For example, let’s say you purchased a 10 year government bond paying a 4% interest rate in 2011. But then during 2012, interest rates moved up to 5%. The value (sale price) of your bond would drop as nobody would want to buy your bond which is paying 4%, when they can get a current bond paying interest at 5%.

The value would drop to a new price that would give the buyer an equivalent interest rate to ‘yield’ 5%. (Note: the calculation can be quite complex and secondly, the value of your bond could go up if interest rates dropped to say 3%). 

Let’s now look at ‘higher’ investment risk

Shares (stocks) are seen as more unpredictable than government bonds. However, over time they have generally provided better returns. With world share markets performing very poorly over recent years, many are challenging if shares have provided a better return. It all depends at to which time frame you use to calculate past returns.

The turmoil in the recent share market performance has highlighted the need to spread your share investments across a number of companies. With even largest companies going under, it’s more important than ever to not put ‘all your eggs’ in one basket.

Ultimately, every investment is not without risk. The trick is to balance risk against your future investment needs.

Some key points to consider before investing are.

• Your time frame – The longer the time frame, the more time you have to recover from potential losses
• The need to access your investment – Money for holidays, buying a house, a car etc Funds for these events would generally be better suited in short term investmens like savings accounts.
• Your personal stress levels –  Losing money is stressful and some people feel the stress more than others. Make sure you feel comfortable with the risk you are taking, as  you don’t want to be losing sleep over your investments!
• Do you need to take additional risks? – Can you live off what you already have? 

One Final Note

Taking fewer risks through investments like bonds and cash does currently mean accepting a very low rate of return, as interest rates have collapsed across the western world. It’s unlikely that these current low interest rates will provide a sufficient return for most investors, to build a big enough nest egg for a comfortable retirement.