What is Risk and Return?

Risk and return in financial management is the risk associated with a certain investment and its returns. Usually, high-risk investments yield better financial returns, and low-risk investments yield lower returns. That is, the risk of a particular investment is directly related to the returns earned from it.

A guide to explaining risk, return and volatility

The aim of this guide is to help you to gain a better understanding of the relationship between risk, return and volatility. To keep things simple, we’ll only be talking about investing in funds, rather than investing in specific companies. It will also offer some useful pointers to help you understand your own attitude towards risk, and hopefully help you to make better investment decisions.

How we define ‘risk’

The concept of risk has many different definitions, but to keep things simple, it makes sense to think about investment risk in three ways:

1. You could lose some or all of your investment

When you make an investment, you hope that it will increase in value and one day be sold for a profit. But there’s no guarantee. There is always a possibility that you end up losing part or all of your investment. Even if your investment grows in value, there’s no guarantee it will perform to your expectations. You can’t rely on an investment’s past performance to be repeated in the future.

2. Your investment may be worth less in the future

It’s also worth remembering that inflation (the rising cost of everyday goods and services) can erode the value of an investment over time. For example, if an investment returns 1.5% every year, but annual inflation rises at 2%, the money invested will be worth less when you look to spend it. This ‘inflation risk’ has become more of a concern in recent years, as very low interest rates have reduced returns available through cash savings accounts.

3. Your investment journey may be uncomfortable

Investments can be volatile, and the riskier the investment, the more unpredictable its return is likely to be. Alternatively, taking fewer risks should make your journey more comfortable, but could mean it takes much longer to reach your destination.

Some investment rules to remember

If you’re considering making an investment, it’s well worth sitting down with your financial adviser to discuss risk, return and volatility in more detail.

Know your objectives

With your financial adviser’s help, you can find the answers to the questions that will help to determine the right investment to suit you.

What are your investment goals?

Are you investing for a short-term goal (like a holiday or new kitchen) or investing for the longer-term, to help pay for your retirement? Understanding your investment timeframe and the return you need from your investment will largely determine the types of investment you should be considering.

How much risk are you prepared to accept?

Would you be comfortable if your portfolio fell in value by 5% over your investment timeframe? What if, in any one year period, it fell by 20%? Answering these questions will help you become more realistic about your personal attitude towards risk and losing money.

Diversification is important

You’ve probably heard the saying: ‘don’t put all your eggs in one basket’. In the investment world, this phrase is summed up in one word – diversification. No professional investment manager, no matter how experienced or gifted, can predict exactly which investments will perform well in any given year. So it makes sense to diversify – or spread – your money across a number of investments as broadly as possible, preferably across different assets, investment types, sectors and geographical regions.

The value of investments can fall as well as rise and you may not get back the amount originally invested.