Beginner

The Relationship Between Risk and Return Explained

There is no such thing as zero risks. It doesn’t exist. If someone offers you a zero-risk investment, you’d likely to better off betting on 32 on the roulette wheel. How we assess risk has everything to do with our expected return.

Some people are risk-takers. Others are cautious players. For most of us, it’s not that simple. You may take risks with your money, but play your career very safe. Others do the opposite. 

Meet John and Stewart

Stewart likes his coffee with one cream, no sugar. John likes his Scotch neat. 

Stewart commutes 45 minutes to work so he can live in a more economically available area. John walks to work from his downtown apartment.

Stewart entrusts his money to GICs and Government Bonds. John invests his money in Cryptocurrencies and Overseas ventures. 

Stewart wants to make sure he receives 3.2% per year on his money. John wants a double or a triple. 

Who is right? Who is wrong?

Stewart takes a risk-averse approach and wants a sure thing over the risk. John is willing to take some risk, but when he goes, he wants a big payoff. 

You may desire to be one side or the other. The fact is there is no “right way.” Each person’s desired outcome will connect to their risk tolerance. 

Neither person is ever entirely on one side of the spectrum. It’s essential to realize what your tendencies are to get the maximum benefit. 

You Risk what you Expect to Gain.

I have a love/hate relationship with cars. 

I like how they feel and the engineering behind them. When I pay more for a car, I expect it to be better engineered and drive faster. I’m risking my $65,000 on a BMW because I EXPECT it to deliver a fast driving experience.

When I only risk $35,000, I expect to have a reliable vehicle that is good on gas mileage. Put up only $7,800 for a car, and my expectation of quality is lowered to the floor. 

Investments follow the same philosophy but track a different metric. Putting more money into an investment doesn’t mean it’s any better. The metric used is the rate of return.

Someone offering you a return of 20% each year sounds much better than an Index fund of 8%. Why would you ever accept that 8%? 

More Money, More Risk

Returns that advertise above industry returns have risk attached to them. If they didn’t, then everybody would flock to them. That would be the new industry average. 

The stock market (S&P 500) has a base return over 12% since 1980 and a yield of 8% in the last 20 years. Therefore, in the previous 20 years, I would need a return better than 8% to have an increased risk above an Index fund. 

A return of 15% per year would be 87.5% better than the Index Fund. Your risk should be equal to that increased return. Double the money, double the risk.

How dangerous is doubling my risk? 

It may not be as bad as you think. When measuring an individual stock’s risk, there is a term used called Beta. We have another article dedicated to Beta. For our purposes here, think of Beta is a measurement of stock risk, and the market as a whole is 1.0. 

Everything being equal, we would expect our investment that is 87.5% riskier, to have a Beta of 1.875. Anything below that and it’s a sound risk/reward scenario. Above that and investor beware. 

If you are looking at investments that are promising your money doubled, tripled or higher, you can only imagine the risk levels. In order to double your money, your risk would be around 12.5X greater than the stock market  

Some people are not comfortable with that level of risk, while others are fine with it. As it turns out, managing multiples of risk have become an industry of its own. 

Risk as a Business

During the last 20 years, dozens of Venture Capital investment firms have been formed. These firms, known as VCs, are a tasked with finding the Unicorns of the world (companies that can go public with valuations over one billion).

VC firms do not look for returns of 10%, 15%, or even 100%. Their goal is to 10X – 20X their funds under management.

How they go about doing this is all about managing risk. Risk is subjective to them. They know if they put 10 million dollars into Company A, there is a 90% chance Company A will go broke.

There is an even smaller chance that the company will get to the stage where they can go public. The numbers show less than a 3% chance that the company will go public.

Given that the chance of a VC investment being only 5%, the expectation of return on the 5% of companies has to be quite large. They need the 20X returns to compensate for all the losses.

You may believe this risk to be unwise, but the math is sound. It validates the risk/reward equation and shows a positive return over the stock market. Several great companies wouldn’t be possible without this type of investment.

Take-Aways

The investment world contains many different options that cater to people’s risk and reward comfortability. Knowing what you need in return will assist you in finding the correct risk level for you.

  • The yield you get on your investment has a direct connection to the risk you are accepting.
  • Calculate the investment’s Beta to determine if it’s a favourable risk/reward or not.
  • Risk can be sky-high, as long as rewards are sky-high as well.