Risk and return are, effectively, two sides of the same coin. In an efficient market, higher risks correlate with stronger potential returns. At the same time, lower returns correlate with safer (lower risk) investments. Together these concepts define how investors choose their assets in the marketplace, and they define how investors set asset prices. Let’s break down how this relationship affects your investments.
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How Risk and Return Are Defined
The level of risk that investors take on is determined by how much money they could lose on their original investment. Risk can refer to both the possibility of a loss and the magnitude of that loss. For example, when an investor calls a particular investment “high-risk,” they might mean that there is a good chance you will lose money, that there is some chance you will lose all of your money or both.
Your return is the amount of money you expect to get back from an investment over the amount that you initially put in. An investment has posted a return if it generates even a single penny more than your initial investment. Though a return can also refer to the amount of money lost if you express it as negative numbers. Regardless, returns are generally expressed as percentages of original investments.
When an investment functions well, risk and return should highly correlate. The higher an investment’s risk, the greater its potential returns should be. By contrast, a very safe (low-risk) investment should generally offer low returns. This is due to bidding mechanics in the marketplace.
Risk and Return, an Example
Let’s say Bond A and Bond B are two potential investments. For Bond A, investors have a 10% chance of nonpayment. Bond B has a 50% chance of loss. Absent any other information, investors will choose Bond A because this offers them a better chance to keep their money. To compete, Bond B has to raise the interest rates that it offers until this return outweighs the risk of nonpayment. At that point Bond B can attract investors despite its higher risk.
By comparison, Bond A, can keep its interest rates low because its low risks will attract investors on their own. However, if Bond B raises its interest rates so high that it begins to dominate the marketplace, Bond A will have to also raise its own interest rates to attract back some investors. But if Bond A can reduce its risk relative to return even further, it will begin to attract back investors based on these more favorable terms. And Bond B then will have to either increase its return even further or find a way to mitigate risks of nonpayment.
A higher risk investment must offer correspondingly high returns in order to offset the downside posed by its risks. The returns are what draw some investors in, even as the risk will deter others. By contrast, a lower risk investment can offer relatively low rates of return, as the safety of this investment is what draws investors in.
You should keep in mind that some financial experts argue that safer investment portfolios outperform riskier ones over time.
How Risk and Return Affect Prices
One of the most important aspects of the relationship between risk and return is how it sets prices for investments. In an efficient market, which is a market that assigns prices based on the value of the underlying assets, an asset’s price reflects the balance between its risk of loss and its potential return. Here are three hypothetical investments:
- Asset A: 100% chance of a $5 return, 0% chance of total loss;
- Asset B: 50% chance of a $5 return, 50% chance of total loss;
- Asset C: Guaranteed total loss within one year.
In this case, we would expect the market to price these assets based on the balance between the risk of loss and the money you would expect to get in return. If we disregard issues such as the time value of money (an asset’s value is always discounted by the amount of time it will take to pay you its returns, since money today is worth more than money tomorrow), we would expect our hypothetical investments to price out as follows:
- Asset A: This asset is worth almost exactly $5. If you know you will receive $5 from this asset with absolute confidence, then holding it is the equivalent of holding cash.
- Asset B: This asset is likely worth $2.50. It’s 50/50 whether you will get $5 or $0. Some investors won’t like that risk, while others won’t want to miss out on the potential return. Between those groups, we would expect prices to settle on a middle ground.
- Asset C: This asset is worth nothing. You know that you will lose all of your money if you invest in this asset, so holding it is the equivalent of setting cash on fire.
This is, of course, a hyper-simplified example. Many external factors such as information asymmetry, inflation, systematic risk, time value of money, capital flow, supply and demand, etc., modify this essential pricing structure. However, the price of an asset in an efficient marketplace begins with the balance between how much money that asset will return balanced against how much money that asset will lose.
How Uncertainty Affects Risk and Return
When investors evaluate risk and return, they have to take into account that there is a level of uncertainty when it comes to investments. The numbers that investors use to express their decisions convey a sense of mathematical certainty to the market, but ultimately risk and return calculations express probabilities. As an example, if an investor says that an asset has a 10% risk of loss, what they mean is that based on market conditions, the asset’s historical patterns and the behavior of similarly situated assets, they expect that there’s a 1-in-10 chance of loss going forward.
You should note that every asset has a different risk and return profile that depends on a number of factors, including the the type of asset, the market in which it is traded and economic conditions at large.
Risk is expressed as a percentage. So when a broker says that an asset has a 25% risk of loss, they mean that they expect one out of four investors to lose money on that investment.
Return is also generally expressed as a percentage and is calculated based on risk. If someone says that you can expect a 10% return this means that, after accounting for the potential risks involved with an asset, investors over time can expect to get back 10% more than they put in. (Note that this means some investors will make more than 10% while others will lose money, because the risk is calculated into the overall return.)
For retail investors, it’s essential to understand this uncertainty. When a broker tells you the risk of a given investment, they’re expressing this to the best of their professional judgment. Independently from a professional’s assessment, you should note that safe investments can lose money, risky investments can clean up. And that risk and return are expressed in probabilities. So it’s important to plan out your investment carefully to protect your money.
Bottom Line
Risk takes into account that your investment could suffer a loss, while return is the amount of money that you can make above your initial investment. In an efficient marketplace, a higher risk investment will need to offer greater returns to offset the chances of loss.
Investment Tips for Beginners
- A financial advisor can help you gauge the risk of an investment opportunity. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- When planning your investments, you will need to determine how much risk you want to take on. This guide will help you figure out your risk tolerance.
- Don’t forget to factor in capital gains taxes when considering whether to sell an asset. Short-term gains are taxed as ordinary income and long-term gains are taxed at more favorable rates. SmartAsset’s free Capital Gains Tax Calculator can help you estimate your tax liability.
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