If you’ve followed along on the blog thus far, you should understand that with investing, there is always a certain amount of risk involved. I hope I’ve made that clear across several different posts.
In those previous posts, I never really delved all that deeply into what that risk is or what its relationship is to investment return.
The hard truth is that you can’t have one without the other. All investing involves risk.
So let’s then dive in to a discussion of risk. What is risk, as applied to investing? Why does it matter? And when it comes to investment returns, what role does risk play?
What Is Risk?
When you start talking about risk in investing, you quickly run into an issue: In investing, risk is defined multiple ways because there are multiple ways to measure it. Many of these definitions of risk are therefore more technical than what I need to get into here, so please indulge me as I define it appropriately for our purposes in this blog post.
Risk is the chance that your investment performance will deviate from its expected performance.
Put more practically: Risk means you might not make as much money with your investments as you need or want to make.
Let’s illustrate my definition of risk (in bold above) with an example.
Let’s say that you began investing on the first market day of the year 2000: Monday, January 3. You invested exactly $10,000 in the Vanguard S&P 500 Index Fund (VFINX), which tracks the S&P 500 market index. (More on indexes and index funds in future blog posts.)
You expected to earn a decent return on that $10,000 over the next ten years. After all, a decade is a good length of time when it comes to investing.
Surely the stocks in the S&P 500 would do pretty well over ten years, right? That’s the 500 largest stocks in the U.S. stock market, and you were invested in all of them through your index fund!
But guess what actually happened to your investment from Monday, January 3, 2000 through Thursday, December 31, 2009.
At the close of the market on December 31, 2009, your $10,000 had become $9,016. Yes, you’re reading that correctly: You actually lost money. Ten years for your investment to grow, and instead of growing, it actually was reduced.
But what would have happened had you instead decided to invest that $10,000 in something much less risky: the Vanguard Intermediate-Term Treasury Fund (VFITX)? That fund consists of nothing but U.S. government securities. (Go back to my “What Are Bonds?” post if you need a refresher on what we’re talking about here.)
At the close of the market on December 31, 2009, your $10,000 would have become $19,160.
Now, was that the expected outcome? Were the vast majority of teams of analysts at the most prestigious financial firms in 1999 expecting stocks to experience a negative compound annual return over the next decade and for bonds to beat stocks so handily? Of course not.
But that’s risk.
What I just used as an illustration above is what those versed in market history frequently refer to as the “lost decade.” In other words, over the course of that ten years, for someone who remained invested in the entire stock market (or much of it), stocks basically went nowhere.
There were reasons for this, of course. The two largest were the dot-com bubble of 2000 and the global financial crisis of 2007-08. That’s neither here nor there for our purposes in this post, though I do highly recommend that every investor learns some market history (perhaps good material for some future blog posts!).
The point is that regardless of the causes, from 2000-2009, it happened: Actual investment performance did not meet expected performance.
Again, that’s exactly what we’re talking about with risk. There is always the chance that your investment performance will deviate from its expected performance. Could a 2000-2009-like decade happen again to the stock market? Of course it could. Will it? Who knows?
So then, defining risk as we have, how should we think about the relationship between risk and return?
How Do Risk and Return Relate?
You might recall in the previous posts about stocks as an asset class and bonds as an asset class that I indicated that stocks were inherently riskier than bonds. That’s true.
But to help us understand the relationship between risk and return, let’s list out several assets in order from the smallest amount of risk to the highest amount of risk (ignoring other assets not included in this list):
- Cash
- Government bonds
- Corporate bonds
- Large company stocks
- Small company stocks
The point of showing a spectrum of risk with these assets in light of the illustration above is to bring us to this observation:
In order for someone to be willing to take on more risk, he or she must be incentivized to do so.
Why is that the case? Here’s an easy-to-understand example using our list above:
Let’s say that in researching some investments, I see coming up a new-issue 10-year Treasury note with a 6% coupon rate (that ain’t happenin’ in the real world, but work with me here in this example).
But I also find an individual stock of a company, and based on research for that company, I determine I can reasonably expect to earn roughly the same 6% return (or maybe a little more) over that same 10-year period if I invest in that company instead of in the bond, assuming the company performs as expected. (Analyses like these are actually much more technical than I’m making them out to be here, but again, this is a simplified example.)
Would I invest in the company stock? I wouldn’t. I would invest in the bond, as would pretty much all other rational investors. Why?
Because investing in the bond is not as risky as investing in the stock, yet it earns roughly the same return.
Now let’s discuss why the bond is not as risky as the stock.
First of all, the bond issuer is the United States government, so the risk of the issuer defaulting on the bond is next to zero. I don’t have to worry about whether or not I will be paid that 6% return. It’s all but guaranteed.
Secondly, in the case of the company, it could be that my investment analysis is actually incorrect, or at least inaccurate enough that I have actually misjudged the company and its expected performance.
Thirdly, it could be that my analysis of the company is actually on target, but the company inevitably does not perform to expectation due to unforeseen circumstances, and that the price of the company’s stock decreases over that ten years and never recovers.
Fourthly, it could be that I had no idea the company was engaging in illegal business practices (as did no other investors) and that, after discovery and a lengthy legal process, the company goes bankrupt and I lose all the money I invested in the company.
Fifthly, it could be that due to overall market forces, the stock market on the whole actually experiences a decline over that ten years, similar to the “lost decade” from the example near the beginning of this blog post. As a result, the company, though expected to be solidly profitable, still experiences a massive share sell-off along with the rest of market and doesn’t recover by the end of the ten years.
Sixthly . . . well, you get the idea.
The point is–which I’m sure you’ve realized–I could invest in the bond or invest in the stock for roughly the same expected return (6%), but one asset is way riskier than the other.
As a result, the rational investor would, of course, choose to invest in the bond. Granted, those were two isolated possible choices among many, many others, but I think you understand what I was doing.
More Risk, More Potential Return
In wrapping up the relationship between risk and return, then, the easiest way to think of the relationship between risk and return is like this:
The more risk one is willing to take, the more return he or she should expect to receive.
In other words, as I said earlier, investors have to be incentivized to purchase riskier assets by the possibility of earning higher returns. Note that I emphasized “possibility.” As always, there are no guarantees when it comes to investment performance.
After all, if there is a possibility for higher returns for a riskier investment, that also means the possibility for higher losses.
Let’s end by going back to the beginning of the post with our risk definition:
Risk is the chance that your investment performance will deviate from its expected performance.
Your investment might do better than expected, or it might do worse.
The key, then, with risk in investing is never to bear too much or too little risk.
If you bear too much risk, you could experience disastrous losses. If you bear too little risk, you might not earn a sufficient return to meet your financial goals, most importantly a financially secure retirement.
How do determine how much risk is right for you? We’re getting there on this blog.
Stick with me.