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Risk vs. Return: A Fundamental Tradeoff

By John M Gannon

A fundamental investment concept is the tradeoff between risk and return. The concept is based on two realities of investments and investment performance.

First, all investments carry some degree of risk – the reality that you could lose some or all of your money when you buy stocks, bonds, mutual funds or other investments. Second, not only do different types of investments carry different levels of risk, but the more risk you assume, the greater the investment return you are likely to achieve.

Risk comes in many forms, but when talking about the risk-return tradeoff, the primary measure of risk is volatility, or the degree to which an investment fluctuates in price. Different asset categories are subject to different levels of price fluctuation. For instance, stocks can fluctuate widely from one year to the next (or even from one day to the next), whereas the swing in bond prices tends to be less dramatic, and price fluctuations for money market or so-called capital preservation investments are even lower.

What’s Your Time Horizon?

Since the investments with the highest potential for return also tend to fluctuate most widely, your investment time horizon – when you will need your money – is an important consideration and is tied closely to the risk-return tradeoff.

For example, while it is true that stocks have returned more than 10 percent on average per year during the course of the eight decades in which Ibbotson Associates has tracked performance, it is also true that stocks have experienced sharp ups and downs, and the major stock indices have actually lost money during many periods of one year or longer.

For this reason, stocks tend to be prudent investments for those with a long-term investment time horizon. The Securities and Exchange Commission notes in its brochure, Beginners' Guide to Asset Allocation, Diversification and Rebalancing: “As an asset category, stocks are a portfolio's ‘heavy hitter,’ offering the greatest potential for growth. Stocks hit home runs, but also strike out. The volatility of stocks makes them a very risky investment in the short term.”

As your time horizon shortens, you generally need more stable investments. As you age, adjusting your portfolio to include a greater percentage of bonds is usually recommended – not only because bond prices fluctuate less than stock prices, but because bonds and stocks tend to move in different directions. In other words, when stock prices rise, bond interest rates often fall, and vice versa.

As you approach or enter retirement, when few can afford sharp declines in the value of their investment assets, it is prudent to move a greater percentage of assets into low- or no-risk assets such as cash and cash equivalents, including savings deposits, certificates of deposit, treasury bills, money market deposit accounts and money market funds. While these are the safest investments, they offer the lowest return of the three major asset categories.

Evaluate Your Tolerance For Risk

Your risk tolerance will depend in part on how much money you can afford to lose – which, for most investors, is not a large percentage of one’s total investment amount. But risk tolerance also involves how well you emotionally handle the ups and downs of the market. If the market’s short-term peaks and valleys don’t bother you, you have a higher tolerance for risk and probably are more likely to risk losing money to achieve better results. On the other hand, if you’re prone to worrying about fluctuations in the value of your investments, you have a lower tolerance for risk and may feel better about allocating your investments to assets that do not fluctuate as much, such as bonds, even when you have a relatively long investment time horizon.

Even if you shrink from market risk, remember that there is also the risk that low-return investments won’t provide the long-term growth you need to build investment value over time, especially during periods of high inflation where your rate of return may be less than the rate of inflation.

Risk tip: If you and your spouse are investing together, it’s a good idea to evaluate each other’s risk tolerance so each investor is comfortable. You want to select investments that allow both of you to sleep well at night!

Try This At Home

It’s a good idea to know the risk-return profile of your investments. If you are participating in the Thrift Savings Plan (TSP), you might want to start there. Ask yourself these questions:

  • How many years do I have until I reach age 65 (normal retirement age)?
  • How comfortable am I with taking on risk?
  • Which funds am I invested in, what do they invest in and what has been their historical return (investment and historical return information can be found on the TSP website: www.tsp.gov)?
  • Am I taking on too much risk – for example, am I nearing retirement and have most of my money in stocks (C, S and I funds)?
  • Am I taking on too little risk – for example, do I have decades before I retire and have most or all of my money in low-risk/low-return investments (such as the G fund)?

Autopilot Reallocation

Investors are increasingly putting their risk-reward decisions on autopilot through lifecycle funds. The assumption underlying these funds is that participants with longer investment time horizons are both willing and able to tolerate more risk (up and down swings in an investment portfolio) while seeking higher rates of return. Another basic assumption is that as participants approach the time when they will begin to withdraw their assets from the plan, their portfolios should be adjusted to reflect a lower tolerance for risk.

If you’re young and won’t be retiring for many years or even decades, you would invest in a lifecycle fund containing investments with higher risk and higher potential returns (such as stocks), and less in investments with lower risk and lower potential returns (such as U.S. government securities). The investments in each fund would adjust (reallocate) gradually – and automatically – to low-risk portfolios as the fund's time horizon approaches.

If you are a TSP investor, you can accomplish autopilot reallocation by investing in one of the “L” funds, each of which seeks to maximize risk and return according to a concept known as the “Efficient Frontier.” Over time, the L funds (except for the L Income Fund) will “roll down” the Efficient Frontier. In other words, as their allocations are adjusted each quarter, the funds shift left on the line, becoming less risky, until they eventually merge into the L Income Fund.

The tradeoff between risk and return is one of the key concepts of successful investing. Understanding the relationship between the two will help you invest with confidence.

As risk (volatility) increases, so does the potential for investment return…

Asset Category

Volatility

Avg. Annual Return*

Stocks

High

10.4%

Bonds (long-term corporate)

Medium

5.9

Money Market Funds (Treasury bills)

Low

3.7

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