Opinion: Josh Callaghan
In Part 1 of this series we talked about understanding your individual goals, time horizons, liquidity requirements and risk tolerance.
Following on from Part 1, let’s tackle one of the central themes in investing – risk.
The risk-return trade off
This trade-off is often considered a fundamental building block for understanding many aspects of investing and markets. Let start with risk.
There are many different types of risk, but for the purpose of the risk-return trade off we measure risk in terms of how much the actual return of an investment can deviate from the expected return.
Side note: This is generally framed up as ‘standard deviation’ which is effectively measuring how far the potential outcomes are from the mean. A high standard deviation means there is higher risk, a low standard deviation means the risk is lower.
Take, for example, a term deposit. When you invest your money in a term deposit you might lock in your money for 12 months at a rate of 2%. At the end of that 12 months you will receive your 2% and therefore, the risk in terms of standard deviation is 0.
Alternatively, if you were to buy a share you might expect that this investment will return 7% over the year. The actual outcome at the end of the year could be widely different. The stock may have a fantastic year which sends its profit through the roof and causes the share price to spike. Then again, the stock may lose a significant part of the market, have to cut dividends and the price tanks.
This measure of risk is what is used on the horizontal axis of the graph below.
On the vertical access is return, or perhaps better termed ‘expected’ return. This essentially represents the extra return that an investor may get for taking on additional risk. Typically, this return expectation is determined by the investor but is often informed by long term trends.
I have very roughly plotted some broad asset classes on the risk-return graph above but it’s for illustrative purposes only. For example, a company bond issued to a speculative miner is likely to be further along the risk paradigm then a large multinational blue-chip stock.
In the same way that asset classes have different risk and returns, so do individual investments within that asset class.
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What’s the point?
There are two key takeouts from understanding this concept.
First, it can be a useful framework to assess your own investments. Investors should be more conscious about the trade-off that they’re making when comparing one investment over another, whether it is at an asset class level or an individual investment choice.
Secondly, this trade-off helps to explain the flow of money between assets as the cash rate moves up and down. Let’s say an investor is looking for a 5% return and to achieve that in a low cash-rate environment they have determined that they need to invest 50% of their portfolio in shares and 50% in government bonds. Now, if we fast forward a few years and the cash rate is at 6%, all of a sudden, the investor can effectively de-risk their portfolio by moving their funds into a term deposit and still maintain their target return.
Large institutional investors, such as JP Morgan, will also have this same mentality. Although, institutional investors have the potential to shift the dynamics of a whole asset class. For example, if interest rates fall, bond prices tend to go up. This may be due to money shifting from lower yield assets to existing bonds that offer a reasonable coupon rate. An individual investor’s money won’t have a material impact on price, but institutional money will.
Risk-return trade off is at the core of investing and therefore investment products. It determines where and how money is invested. But, before we get too far into the market side of it (which is Part 3 of this series), I wanted to give you a brief overview of the products mentioned above.
|Risk||Low||Government – Low
Corporate – Med
|Med – High||High|
|Liquidity||High – although likely to forfeit interest if accessed early||Government – High
Corporate – Med to Low depending on the company and terms
|Direct ownership – Low
Indirect ownership – High
|Return||Low||Varies by issuer||Varies by residential, commercial and location||Varies by macro/micro economic factors, company fundamentals and more|
|Access||Direct with bank||Managed investment scheme||Direct, A-REIT or managed investment scheme||Direct, ETF or managed investment scheme|
I hope you’ve found it useful to get a view of the main product categories which should assist you in framing up the risk-return concept.
In Part 3 of this series I’ll take a look at the third and final piece of the puzzle which is the market. You can also read Part 1 of this series, which is all about identifying your investment needs.
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About Josh Callaghan
Josh Callaghan was formerly the General Manager of Wealth at Canstar, having accumulated more than 15 years’ experience in banking and finance, with in-depth product knowledge across retail banking, stockbroking, life insurance, health insurance and superannuation. Josh’s experience combined with his passion for new technology and active role in the fintech community has positioned him as a credible thought-leader on the future of finance. Josh is striving towards a goal of creating a world where building and managing wealth is easy for all consumers.