There is generally a close relationship between the level of investment risk and the potential level of growth or investment returns over the long term. The risk–return spectrum is the relationship between the amount of return gained on an investment and the amount of risk undertaken in that investment. Matthew Seaward, of our Investment Management team, shares his insights into portfolio theories and the relationship between risk and return.
But it does let you get a share of profits if the company pays dividends. Some investments, such as those sold on the exempt market are highly speculative and very risky. They should only be purchased by investors who can afford to lose all of the money they have invested.
DiversificationDiversification A way of spreading investment risk by by choosing a mix of investments. The idea is that some investments will do well at times when others are not. May include stocks, bonds and mutual funds.
Understanding the relationship of Risk & Return - Tradejini
The equity premium Treasury bills issued by the Canadian government are so safe that they are considered to be virtually risk-free. The government is unlikely to default on its debtDebt Money that you have borrowed. You must repay the loan, with interest, by a set date. At the other extreme, common shares are very risky because they have no guarantees and shareholders are paid last if the company is in trouble or goes bankrupt. Investors must be paid a premium, in the form of a higher average return, to compensate them for the higher risk of owning shares.
The liquidity or maturity premium theory of the yield curve holds that required returns on long-term securities tend to be greater the longer the time to maturity. The maturity premium reflects a preference by many lenders for shorter maturities because the interest rate risk associated with these securities is less than with longer-term securities. As we shall see in Chapter, the value of a bond tends to vary more as interest rates change, the longer the term to maturity.
- Understanding the relationship of Risk & Return
- Other useful resources
- Risk and Return
Thus, if interest rates rise, the holder of a long-term bond will find that the value of the investment has declined substantially more than that of the holder of a short-term bond. In addition, the short-term bondholder has the option of holding the bond for the short time remaining to maturity and then reinvesting the proceeds from that bond at the new higher interest rate.
The long-term bondholder must wait much longer before this opportunity is available. Accordingly, it is argued that whatever the shape of the yield curve, a liquidity or maturity premium is reflected in it.
The liquidity premium is larger for long-term bonds than for short-term bonds. Finally, according to the market segmentation theory, the securities markets are segmented by maturity. If strong borrower demand exists for long-term funds and these funds are in short supply, the yield curve will be upward sloping.
Conversely, if strong borrower demand exists for short-term funds and these funds are in short supply, the yield curve will be downward sloping. Several factors limit the choice of maturities by lenders.
One such factor is the legal regulations that limit the types of investments commercial banks, savings and loan associations, insurance companies, and other financial institutions are permitted to make.
Another limitation faced by lenders is the desire or need to match the maturity structure of their liabilities with assets of equivalent maturity. For example, insurance companies and pension funds, because of the long-term nature of their contractual obligations to clients, are interested primarily in making long-term investments.
Commercial banks and money market funds, in contrast, are primarily short-term lenders because a large proportion of their liabilities is in the form of deposits that can be withdrawn on demand.
At any point in time, the term structure of interest rates is the result of the interaction of the factors just described. All three theories are useful in explaining the shape of the yield curve. The Default Risk Premium U. In contrast, corporate bonds are subject to varying degrees of default risk. Investors require higher rates of return on securities subject to default risk.
Over time, the spread between the required returns on bonds having various levels of default risk varies, reflecting the economic prospects and the resulting probability of default. For example, during the relative prosperity ofthe yield on Baa-rated corporate bonds was approximately.
By lateas the U. In mid, the spread narrowed to 0. The spread expanded to 0. These are higher up the range because the maturity has increased. The overlap occurs of the mid-term debt of the best rated corporations with the short-term debt of the nearly perfectly, but not perfectly rated corporations.
In this arena, the debts are called investment grade by the rating agencies. The lower the credit rating, the higher the yield and thus the expected return.
The risk-return relationship | Understanding risk | hidden-facts.info
Rental property[ edit ] A commercial property that the investor rents out is comparable in risk or return to a low-investment grade. Industrial property has higher risk and returns, followed by residential with the possible exception of the investor's own home.
High-yield debt[ edit ] After the returns upon all classes of investment-grade debt come the returns on speculative-grade high-yield debt also known derisively as junk bonds.
These may come from mid and low rated corporations, and less politically stable governments. Equity[ edit ] Equity returns are the profits earned by businesses after interest and tax. Even the equity returns on the highest rated corporations are notably risky.
The risk-return relationship
Small-cap stocks are generally riskier than large-cap ; companies that primarily service governments, or provide basic consumer goods such as food or utilities, tend to be less volatile than those in other industries. Note that since stocks tend to rise when corporate bonds fall and vice versa, a portfolio containing a small percentage of stocks can be less risky than one containing only debts.
Options and futures[ edit ] Option and futures contracts often provide leverage on underlying stocks, bonds or commodities; this increases the returns but also the risks. Note that in some cases, derivatives can be used to hedgedecreasing the overall risk of the portfolio due to negative correlation with other investments.
For example, the more risky the investment the more time and effort is usually required to obtain information about it and monitor its progress. For another, the importance of a loss of X amount of value is greater than the importance of a gain of X amount of value, so a riskier investment will attract a higher risk premium even if the forecast return is the same as upon a less risky investment.Introduction to Risk and Return
Risk is therefore something that must be compensated for, and the more risk the more compensation required. If an investment had a high return with low risk, eventually everyone would want to invest there.