Risks and Rewards of Investing in the Stock Market

Stock Market Risk Management

Generally, the higher the potential return of an investment, the higher the risk. There is no guarantee that you will actually get a higher return by accepting more risk.

There is a positive correlation between risk and return—with one important caveat. There is no guarantee that taking greater risk results in a greater return. Rather, taking a greater risk may result in the loss of a larger amount of capital.

A more correct statement may be that there is a positive correlation between the amount of risk and the potential for return. Generally, a lower risk investment has a lower potential for profit. A higher risk investment has a higher potential for profit but also a potential for a greater loss.

What is Risk-Return Trade-off?

The risk-return trade-off states that the potential return rises with an increase in risk. Using this principle, individuals associate low levels of uncertainty with low potential returns, and high levels of uncertainty or risk with high potential returns. According to the risk-return tradeoff, invested money can render higher profits only if the investor will accept a higher possibility of losses.

Risk and Investments

The risk associated with investments can be thought of as lying along a spectrum. On the low-risk end, there are short-term government bonds with low yields. The middle of the spectrum may contain investments such as rental property or high-yield debt. On the high-risk end of the spectrum are equity investments, futures and commodity contracts, including options.

Investments with different levels of risk are often placed together in a portfolio to maximize returns while minimizing the possibility of volatility and loss. Modern portfolio theory uses statistical techniques to determine an efficient frontier that results in the lowest risk for a given rate of return. Using the concepts of this theory, assets are combined in a portfolio based on statistical measurements such as standard deviation and correlation.

Understanding Risk-Return Trade-off

The risk-return trade-off is the trading principle that links high risk with high reward. The appropriate risk-return trade-off depends on a variety of factors including an investor’s risk tolerance, the investor’s years to retirement and the potential to replace lost funds. Time also plays an essential role in determining a portfolio with the appropriate levels of risk and reward. For example, if an investor has the ability to invest in equities over the long term, that provides the investor with the potential to recover from the risks of bear markets and participate in bull markets, while if an investor can only invest in a short time frame, the same equities have a higher risk proposition.

Investors use the risk-return trade-off as one of the essential components of each investment decision, as well as to assess their portfolios as a whole. At the portfolio level, the risk-return trade-off can include assessments of the concentration or the diversity of holdings and whether the mix presents too much risk or a lower-than-desired potential for returns.

The correlation between the hazards one runs in investing and the performance of investments is known as the risk-return trade-off. The risk-return trade-off states the higher the risk, the higher the reward—and vice versa. Using this principle, low levels of uncertainty (risk) are associated with low potential returns and high levels of uncertainty with high potential returns. According to the risk-return tradeoff, invested money can render higher profits only if the investor will accept a higher possibility of losses.

Investors consider the risk-return trade-off as one of the essential components of decision-making. They also use it to assess their portfolios as a whole.

Risk Tolerance

An investor needs to understand his individual risk tolerance when constructing a portfolio of assets. Risk tolerance varies among investors. Factors that impact risk tolerance may include:

the amount of time remaining until retirement, the size of the portfolio, future earnings, potential, ability to replace lost funds, and, the presence of other types of assets: equity in a home, a pension plan, an insurance policy.

Managing Risk and Return

Formulas, strategies, and algorithms abound that are dedicated to analysing and attempting to quantify the relationship between risk and return.

Known as the SFRatio, is an approach to investment decisions that set a minimum required return for a given level of risk. Its formula provides a probability of getting a minimum-required return on a portfolio; an investor's optimal decision is to choose the portfolio with the highest SFRatio.

Another popular measure is the Sharpe ratio. This calculation compares an asset's, fund's, or portfolio's return to the performance of a risk-free investment, most commonly the three-month Treasury bill. The greater the Sharpe ratio, the better the risk-adjusted performance.  

Measuring Singular Risk in Context

When an investor considers high-risk-high-return investments, the investor can apply the risk-return trade-off to the vehicle on a singular basis as well as within the context of the portfolio as a whole. Examples of high-risk-high return investments include options, penny stocks and leveraged exchange-traded funds (ETFs). Generally speaking, a diversified portfolio reduces the risks presented by individual investment positions. For example, a penny stock position may have a high risk on a singular basis, but if it is the only position of its kind in a larger portfolio, the risk incurred by holding the stock is minimal.

Risk-Return Trade-off at the Portfolio Level

That said, the risk-return trade-off also exists at the portfolio level. For example, a portfolio composed of all equities presents both higher risk and higher potential returns. Within an all-equity portfolio, risk and reward can be increased by concentrating investments in specific sectors or by taking on single positions that represent a large percentage of holdings. For investors, assessing the cumulative risk-return trade-off of all positions can provide insight on whether a portfolio assumes enough risk to achieve long-term return objectives or if the risk levels are too high with the existing mix of holdings.

Some investments are riskier than others – there’s a greater chance you could lose some or all of your money. For example, Canada Savings Bonds have very low risk because they are issued by the government of Canada. GICs and bank deposits also carry low risk because they are backed by large financial institutions. With GICs and deposits you also have the additional protection of deposit insurance on amounts up to $100,000 if your financial institution goes bankrupt. With these low-risk investments you are unlikely to lose money. However, they have a lower potential return than riskier investments and they may not keep pace with inflation.

Over the long-term, bonds have a potentially higher return than CSBs and GICs, but they also have more risks. Their prices may drop if the issuer’s creditworthiness declines or interest rates go up. Learn more about the risks of bonds.

Stocks have a potentially higher return than bonds over the long term, but they are also riskier. Bond investors are creditors. As a bond investor, you’re legally entitled to fixed amounts of interest and principal and are repaid in priority if the company goes bankrupt. However, if the company is successful, you won’t earn more than the fixed amounts of interest and principal. Shareholders are owners. As a shareholder, if the company is unsuccessful, you could lose all of your money. But if the company is successful, you could see higher dividends and a rising share price.

Some investments, such as those sold on the exempt market are highly speculative and very risky. They should only be purchased by investors who can afford to lose all of the money they have invested.

The equity premium

Treasury bills issued by the Canadian government are so safe that they are considered to be virtually risk-free. The government is unlikely to default on its debt because it has the power to raise revenues through taxes and to print money.

At the other extreme, common shares are very risky because they have no guarantees and shareholders are paid last if the company is in trouble or goes bankrupt.

Investors must be paid a premium, in the form of a higher average return, to compensate them for the higher risk of owning shares. The additional return for holding shares rather than safe government debt is known as the equity premium.

Direct Relationship between Risk and Return

(A) High Risk - High Return 

According to this type of relationship, if investor will take more risk, he will get more reward. So, he invested million, it means his risk of loss is million dollar. Suppose, he is earning 10% return. It means, his return is Lakh but he invests more million, it means his risk of loss of money is million. Now, he will get Lakh return.

(B) Low Risk - Low Return 

It is also a direct relationship between risk and return. If the investor decreases investment. It means, he is decreasing his risk of loss, at that time, his return will also decrease.

Negative Relationship between Risk and Return

(A) High Risk Low Return

Sometime, investor increases investment amount for getting high return but with increasing return, he faces low return because it is nature of that project. There is no benefit to increase investment in such project. Suppose, there are 1,00,000 lotteries in which you will earn the prize of You have bought 50% of total lotteries. But, if you buy 75% of lotteries. Prize will same but at increasing of risk, your return will decrease.

(B) Low-Risk High Return 

There are some projects, if you invest low amount, you can earn high return. For example, Govt. of India need money. Because, govt. needs this money in emergency and Govt. is giving high return on small investment. If you get this opportunity and invest your money, you will get high return on your small risk of loss of money.

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