What is Risk versus Return? (and how does this relate to my Risk Profile?)
"There’s no such thing as a free lunch" is an expression that conveys the concept that it is generally impossible to get something for nothing. In investment terms, this means that it is impossible to get financial gains without taking some risk (the chance of losing at least some of the original monies).
Appetite towards risk (the chance of losing some percentage of your investment) can have an immense impact on investment returns, i.e., the gains or losses actually experienced. Put simply the trade-off is, the lower the level of risk (uncertainty) the lower the possible gains and conversely the higher the level of risk the higher the possible gains.
Risk vs Return
It is important to be aware that investing is not a risk-free strategy and there is always a chance you could lose money or not make as much as you expected. All investment asset classes (e.g., cash, fixed interest, bonds, property and shares) carry some risk (uncertainty) due to the impact of factors such as inflation, tax, exchange rates, interest rates and especially, economic cycles.
Different types of investments carry different levels of investment risk and returns. Income assets (incl. cash & bonds) generally provide lower returns and a lower risk of loss, while growth assets (such as property & shares) may provide higher returns but with an attached higher risk.
The below graph illustrates the relationship between risk and return for some asset types:
Understanding your risk profile
To understand your risk profile, firstly, you need to determine what level of investment risk you feel comfortable with before you invest, since your own risk profile or risk tolerance profile will differ from person to person.
Some investors are comfortable taking on more risk (uncertainty) to achieve higher returns and conversely, some investors find it challenging to handle risk, so they keep their money in the bank (i.e. they are fearful of capital losses). We also see investors becoming more risk averse during a downturn or when the economy is going through a bad patch like that of the 1987 Share Crash, the GFC crisis in 2008 or the Covid crisis of 2020.
This ‘attitude to risk’ is validated by investors completing a risk profiling questionnaire. This plays an important part of assessing your attitude to risk but it should not be the sole determinant when assessing a suitable asset allocation for an investment. Rather, it’s a starting point for every discussion.
Other factors that can play a part in determining your risk profile include:
What other investment(s) you have
Your goals and expectations for this particular investment
Your attitudes towards socially responsible and ethical investing
Investment timeframes (e.g., 0 – 3 yrs; 3 – 5 yrs; 6 – 9 yrs or 10+ yrs)
Regular income (e.g. an ongoing payment to supplement a Government pension)
One off withdrawal (e.g. for big expenses like house deposits, home renovations or overseas trips etc.)
Longevity risk With retirement type investments, you should consider the risk associated with living longer as the average life expectancy increases, e.g., as a result of modern medicine improvements. Here, an investor may select a conservative format because they are ‘older’ and place funds in low risk investment products such as cash and TDs. The subsequent returns are likely to be low and, in some instances, the real returns (returns after fees, tax and inflation) may even be negative, especially in a ’low interest’ environment.
Without ascertaining your appetite for risk, you may expose yourself to too much risk, or possibly not attain the returns you would like, based on your investment timeframe.
At Montage, we use a simple concept to explain an investor’s risk profile or attitude to risk and the typically associated timeframes. We rank them from 1 to 5, 1 being very conservative and 5 being very aggressive
Note: If your investment timeframe is less than 3 years (e.g. you intend to purchase a home), it’s generally considered prudent to leave your money in cash type investments such as Cash Funds, Term PIEs, Call Accounts, TDs, etc. And, there are a number of investment funds that offer these shorter-term requirements.
Understanding estimated returns
Estimated returns, the range of returns from ‘expected lows to expected highs’ vary for each risk profile and reflect the mix of growth and conservative assets you hold as shown in the diagram below:
E.g. The balanced profile could fluctuate from -10% to +20% and the growth profile could vary between -17% to +30%.
Note: It is very important to remember that these expected return ranges are not guaranteed and your actual return each year could even be outside of these estimates – in unusual circumstances.
Typical Investment graphs
In the example below, Fund A is a Growth Fund and Fund B is a Conservative Fund. The Growth Fund is more volatile (prices can go up higher and down lower) than Fund B, but overall, the potential return expectation is higher in Fund A compared with Fund B – higher average returns.
Fund B will likely have a less bumpy ride over the years and therefore produce lower average returns.
The trend for each fund is shown in the yellow shaded area.