Investing Essentials: Risk and return, and why they matter

Bennelong Funds Management
Articles
3 min read

16 May 2023

When it comes down to it, the reason anyone invests their money is to turn one dollar into two. While that seems like an obvious statement, for an investor, there are a lot of questions and considerations behind it.

What’s your reason for investing? What’s the specific goal you want to achieve? When do you want to reach that goal? Do you want regular income, capital growth, or both? And, critically, what’s your risk profile?

This last question is at the heart of any investment, and it’s important for you to understand exactly what it means.

Return

Return refers to how much money you make on an investment. That return could appear in a number of ways, such as income (dividends on an investment that are paid or reinvested) or growth (the amount initially invested increasing in value). An investment with a high rate of expected return is expected to perform better than an investment with a low rate of expected return.

Your return profile is how much money you want to make on your investment. That might be to fund high-priority requirements like living expenses or healthcare, or ‘nice to haves’ like a holiday. However, it’s not as simple as deciding you’d like a high return on every investment. This is where risk comes in.

Risk

Risk refers to the likelihood of an investment not performing as it expects – whatever that expectation may be. If you invest in a fund that expects to make a return of 5%, the risk is how likely it is that that fund will not make a 5% return.

Your risk profile, therefore, is how much risk you can tolerate to receive your expected return. That risk is often described as having two parts – the risk that your investment is able to withstand without jeopardising your goals, and also your personal capacity to tolerate risk (sometimes referred to as the ‘sleep at night’ factor).

It’s often this risk profile that determines an individual’s investment path. For example, you may have a long investment timeframe to smooth out short-term periods of market volatility and a solid portfolio that can withstand quite significant risk, but you know that taking on such a level of risk would make you highly anxious – regardless of the outcome. Alternatively, you may feel very comfortable taking on additional risk with the aim of receiving higher returns over the long term.

There is a correlation between risk and return, meaning you’ll often find the higher an investment’s expected return, the higher the level of risk, and vice versa.

An investment could be classified as high risk if there was a significant chance of underperformance or loss of capital, meaning any investor taking on that level of risk would naturally expect a higher level of expected return than a lower risk investment. Conversely, a low risk investment – where there is less likelihood of a loss – will usually have a lower return. Unfortunately there’s no such thing as a high return, zero risk investment!

All of this means it’s important to sit down and work out a robust plan that outlines your own objectives and risk profile, and then match investments to suit. This is where a financial adviser can offer invaluable assistance.

^{The content contained in this article represents the opinions of the author/s. The author/s may hold either long or short positions in securities of various companies discussed in the article. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely as an avenue for the author/s to express their personal views on investing and for the entertainment of the reader.}