For Investments, How Are Risk and Return Related?
Investing is a fantastic way to make your money work for you. The right kind of investment can help you grow your wealth, increase your assets, and fund financial goals such as your dream home, your children’s education, and your retirement.
However, one thing to keep in mind is that every investment comes with a level of risk. In general, the riskier an investment is, the greater its potential returns. Before jumping into any investment, you should evaluate both the investment’s risks and your risk tolerance.
How much of a financial loss can you afford to sustain? How long can you afford to wait before seeing returns? How much volatility can you stomach in the meantime? Understanding the answers to these questions will help you build an investment portfolio suited to your individual needs.
Here, let’s take a look at how the risk profiles of several common investments differ.
The stock market
Most successful investor portfolios feature stocks, which refer to a portion of ownership in companies. Stock investments can generate earnings through capital gains or profit distributions called dividends.
As a stock investor, you have several investment options, each with a unique risk profile. Under the equity portion of an investment portfolio alone, you can achieve a high level of diversification.
Large-cap stocks
A large-cap stock is a public company with a market capitalization of $10 billion or more. Big-cap companies are among the lowest-risk stock investment options because they have an industry dominance and generate stable earnings. These companies have a low sensitivity to economic downturns, and they are generally profitable during good and bad times.
The extended business tenure of a large-cap company makes it easier for investors to gather information on its profitability, operations, and historical performance. Access to accurate data allows investors to exercise due diligence and make calculated investment decisions.
The dividend payouts of large-caps are generally steady. However, mature companies that are well established in the market no longer experience rapid growth. With large-cap investments, there is a high risk for low capital appreciation and stagnant share prices.
Small-cap stocks
Small-cap stocks are companies with market caps ranging between $300 million and $1 billion. Investing in small-caps is significantly riskier than investing in large-caps, but there is a potential for high returns.
The high risk of small-cap stocks is, in part, due to their low liquidity. In other words, they may be difficult to sell quickly at a price that reflects their intrinsic value. A small-cap company’s access to financial resources may also be limited, making them more susceptible to downward economic cycles.
The risks of investing in small-cap stocks are relatively high, but so are the potential returns. Small-caps have a long runway to generate growth, and they are more adaptable to changes in the market than large-caps. In sectors with few competitors, undervalued stocks can generate high returns over the long haul.
Emerging market stocks
A significant risk of holding emerging market stocks for long periods is that it exposes investors to downturns resulting from political and economic crises, which generally last longer in emerging markets. Compared to the U.S. dollar, emerging market currencies can also be highly volatile.
On the upside, the correlation between the developed and emerging market is generally low, providing investors with diversification benefits. The potential for growth in emerging markets can also be higher than those in developed economies.
Bonds
Generally, bond investments are less risky than stock investments because the bond issuer promises to return the security’s face value at maturity. Bond issuers also have an obligation to pay an interest income at a fixed rate, where stock issuers have no obligation to pay dividends.
However, bond investments are not without risks. Interest rate fluctuations result in bond price volatility. Also, when inflation rises to a higher rate than a bond’s rate of return, it will reduce your bond’s purchasing power.
Mutual funds and ETFs
Mutual funds are investment vehicles allowing investors to own hundreds of stocks in one package. With a single purchase, the mutual fund investor owns a diversified stock portfolio, spreading their risk across multiple investments. When investing in mutual funds, investors have to pay significant management fees, even if their investments don’t perform well.
An exchange-traded fund (ETF) is also a basket of securities, but ETFs track an underlying index, allowing for passive management, unlike mutual funds. Index tracking doesn’t necessarily reduce the risk of loss, but it does eliminate manager risk.
Investments outside the stock market
Venture capital
As a venture capitalist, you invest in an early-stage company in exchange for equity. The requirements for receiving accreditation as a venture capital investor include meeting an earned income exceeding $200,000 in each of the prior two years and having a net worth of more than $1 million.
Venture capital investments are usually unsecured, and companies requiring venture capital generally have an innovative and unproven business model. Consequently, venture capital investments are high-risk.
However, if the business has an excellent track record, sustainable growth prospects, and operates in a growing market, the potential returns are significant.
Real estate
Real estate investments are literally as safe as houses. Property is a tangible asset within a steady market, and it can offer a hedge against inflation. Unlike stocks, the price of a property can never drop to zero.
When investing in property, there is a risk of hidden costs reducing your return on investments. Before purchasing property, consider costs such as property taxes, repair and maintenance costs, HOA fees, and loan fees.
Farmland and agriculture
Risks associated with farmland and agricultural investments include disasters, such as pest infestations, fire, drought, or illnesses, which can reduce yields. Unexpected regulatory restrictions on agricultural practices can also affect investment returns.
On the upside, the agricultural sector produces food, which will always be in demand. Farmland also outperforms most other asset types in terms of capital appreciation and earnings.
Gold and other commodities
Investing in gold and other commodities is a high-risk, high-reward strategy. Commodity futures are leveraged instruments, which means little upfront capital is necessary to control relatively large market positions. While using leverage with commodities may magnify your returns, it can also magnify your losses.
The potential returns of commodity investments are substantial. For example, growing supply constraints in the gold sector are steadily increasing the gold price. The increasing demand for gold among investors and other parties are also driving the price increase.
Your own business
Starting a new business is an inherently risky endeavor, especially if you have limited resources and require an income to support your household. If a business fails, you can potentially lose everything.
The risks new business owners face include market saturation or low demand for products and services, unexpected costs, operational failures, and financial risks. A new business is also an asset that is relatively difficult to liquidate, and it lacks diversification.
However, with sound risk management, the potential rewards of starting your own business can be higher than those of any other investment type. Starting a business that solves problems and adds value is one of the only ways to generate millions of dollars from very little or nothing.
Conclusion
Before adding new assets to your portfolio, you should formulate a list of well-defined investment objectives. Along with goals in terms of growth, income, preservation, and tax efficiency, you should also pay careful attention to your risk tolerance.
Each asset class has a unique risk profile, and a careful evaluation of the asset’s potential performance is critical before purchase.
