Understanding the relationship between risk and return

January 4, 2016

Ensure you have the right balance when investing.

Volatility as a measure of risk

For the purposes of this article, risk is measured in terms of volatility, which is the range of possible returns that an investment may deliver. For example, one investment could decline 20% one year and rise 35% the next, while another may drop 4% and possibly rise 3% the following year.

Let’s take a quick look at where bonds and stocks are on the spectrum of risk.

Bond risk

Bonds are generally less risky than equities, but it does depend on the type of bond, of which there are many. Government bonds are generally the most secure while investment-grade corporate bonds (meaning corporate bonds that are rated as having a low risk of default) are also considered a secure investment, though somewhat riskier than government bonds. High-yield bonds are less secure still as they are issued by companies with potentially lower credit ratings and can be volatile in certain market environments. Interest rates (coupons) and return expectations rise in relation to bond risk. For example, high-yield bonds typically generate higher returns than government bonds, but also entail more risk.

Equity risk

Stocks aren’t rated the same way that bonds are, so categorizing them according to risk is more difficult. As mentioned above, a good measure is volatility (i.e., how wide a stock price may swing over a given time period).

Generally, stocks of well-established, large companies from developed economies like the U.S. are less volatile than stocks from emerging markets economies, such as China and Brazil. Stocks of smaller companies, even in developed countries, tend to be more volatile but offer more growth potential as well. Remember, with higher volatility comes the potential for higher returns … and losses.

A note on diversification

As you can see, different investments have different risk-return profiles. Some bonds are more volatile than others, and the same goes for stocks. This is why it’s important to diversify your investments. A portfolio of 100% government bonds will behave somewhat predictably: low returns without much price movements.

 

Conversely, a portfolio of 100% equities will be unpredictable over the short term. But, if history is a guide, equities generate higher returns over the long term. For most investors, owning a well-diversified mix of different types of stocks and bonds will reduce overall portfolio volatility (i.e., risk) and offer the potential for enhanced long-term returns.

Know your goals

If you have short-term goals, e.g., if you’re saving to go back to school in two years or saving for a down payment on a house, less-risky assets such as guaranteed investment certificates (GICs), short-term government bonds or a fixed-income or balanced mutual fund are likely to be the most appropriate. If you’re investing for your retirement in 30 years, you can add more equities to your portfolio to increase the growth potential of your portfolio.

Speak to a financial advisor

People often err on the side of caution when investing. That means they invest in a significant amount of less-risky investments, such as GICs and bonds, which can result in lower returns. If you are investing for the long-term, however, it may be worth diversifying your portfolio with a variety of asset classes and holdings with varying risk profiles in order to achieve a certain rate of return to meet your goals. 

To learn more about the relationship between risk and return, visit AGF.com/RethinkRisk and talk to your financial advisor.

The contents of this Web site are provided for informational and educational purposes, and are not intended to provide specific individual advice including, without limitation, investment, financial, legal, accounting or tax. Please consult with your own professional advisor on your particular circumstances.

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