“There’s no such thing as no risk.  There’s only the choice of what to risk and when to risk it.”

– Nick Murray, Simple Wealth Inevitable Wealth

I love this quote because it epitomises investing.  You can’t build wealth without investing and you can’t invest without exposing yourself to some form/s and degree of risk.

The correlation between risk and return is not a new one – it’s eons old.  General the higher the risk, the greater the expected return on the investment made.

When people think of risk, they turn their minds to lose the money they’ve invested.  But there are other types of risk that exist.  For example, risk can encompass income risk, return risk, inflation risk and interest rate risk to name but a few.

Whist we usually appreciate the relationship between risk and return, we often don’t consider the correlation that can differ amongst asset classes.  Moreover, we fail to use this as a risk management tool.  Yes, that’s right … using the relationship between risk and return can lead us to invest in different things, which in turn can reduce the risk our coin is exposed to.  A picture speaks a million words so have a look at this diagram:

Higher Risk Higher Return

Assets that tend to produce greater returns are shares and property.  While it’s expected these assets will produce higher returns over the long term, they’re subject to a higher degree of risk.  The purpose of investing in these assets is to grow your investment, usually on the capital of the investment itself.  As their purpose is to increase the original capital invested, they’re universally referred to as ‘growth assets’.

Lower Risk Lower Return

As you’d expect, the assets that carry less risk, such as putting your money in a savings account, holding it in a fixed interest term deposit or in bonds, produce lower returns for you.  But make no mistake – some risk still exists.  The main purpose behind investing in term deposits or bonds is usually to receive some form of income from them such as bank interest.  I think of these assets as being defensive against any ups and downs the market experiences, because usually, irrespective of market turbulence, the investor receives a fixed return from their investment.

Summary

Savvy investors understand the relationship between risk and return.  They’ll use this relationship to their advantage, building wealth using a mixture of growth and defensive assets, invoking another age-old concept known as diversification.  We’ll discuss this concept in future articles but in the interim, happy investing.