Why is Risk More Important Than Return While Considering Your Next Investment?
In finance, you will often hear people say “no risk, no gain” while talking about investments. It is observed that higher risk generates higher rewards, causing people to give in to their greed and pick trades or assets that are too risky and consequently losing money. It can be thought of as two ends of the same scale. On the first end, which is the low-risk end, government bonds with low yields and short term are present. These are short-term bonds with low returns. The middle range may contain investments such as rental property or high-yield debt. The other end of this scale would consist of equity investments, futures, and commodity contracts, including options. They say that you must continuously diversify your portfolio; this indicates that assets with different levels of risk should be placed together in a portfolio to maximize returns while minimizing the possibility of volatility and loss. People often do so using Gold.
Hedging is a risk management strategy used to compensate losses in investments by taking an opposed attitude in a related asset. The decrease in risk given by hedging also typically results in a drop in possible profits. Hedging transactions revolve around tactics related to assets such as derivatives, such as options, and futures contracts. One ubiquitous hedge is gold. Gold still holds the value of a hedging instrument simply because it lacks credit or default risks. Gold prices go up when the interest rate goes down, which is directly proportional to the economy’s strength. So, in a broad sense, Gold is a hedge against a falling economy.
Explain the risk and return trade-off and follow the risk-return trade-off with an example. Any asset with high risk will have the prospect of a high return. So, if the risk in an investment is high, the possibility of return is also high, around 20-25% annually, and may not be limited to just 6-8%. This means that the investment return is unstable and may shift depending on market changes. However, the average return on equity would usually range between 12-15% annually. Alternatively, if the risk in any particular investment is low, for instance, in a fixed bank deposit, the chances of getting 20-25% annually will never happen. The returns will range between 6% to 8%. However, it also means that the return can never be lower than 6%, significantly negative. This is a trade-off between risk and return.
Some of the most significant risks associated with an asset are as follows:
- Inflation risk: It refers to inflation reducing the purchasing power of cash over time.
- Credit Risk: The credit rating of assets determine their value
- Liquidity Risk: How quickly can you convert your investment to cash?
- Tax Risk: Government may change laws regarding these assets
- Concentration Risk: Buying too many shares or too many units of a particular asset
- There is a market risk because the equity market is volatile.
In this uncertain world, the question for investors is, which is more critical as you seek to reach your long-term goals, playing defence, that is, protecting against losses, or playing offence which implies being aggressive? Think about it mathematically. If you lose 20% in one year, you will need to make 25% the following year to break even. If your goal is to achieve an 8% return annually, you’ll need to earn 35.45% in the next year to offset the loss and catch up to your goal.
In conclusion, Investors should concentrate as much, if not more, on handling risk than returns. Otherwise, there may not be adequate time to return to sufficient levels needed to fund their long-term goals in times of unusual drawdowns.