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The Relationship Between Risk And Return

Most investors view investing as a way to grow their money and also to receive a stream of regular income from dividends. This is obviously not wrong, but the problem here is that most investors tend to look for returns, while only a few acknowledge the risks related to the returns. In this article, I would like to briefly discuss the relationship between risk and return and how an investor should rightfully consider both when making an investment decision.

Understanding risk

Every investor knows that investing comes with risks, but can these risks be quantified? How do we even begin to define these risks? When an investment is made, we usually have a potential return in mind, be it from capital gains from the growth of the underlying business, or in the form of dividends declared by the company. Hence, the return portion can be more clearly defined and imagined, and is thus not as nebulous a concept compared to risk.

Unfortunately, risk cannot be properly quantified, unless you agree with finance academics’ version of risk, which is the volatility in a company’s share price. Risk is also contextual – it is based on the situation you are studying or analyzing, so this makes it harder to visualize.

Low risk, high return?

There is a popular saying which states that “high returns come with high risk.” This notion was shot down by the famous investor Howard Marks, who wrote in one of his client memos that high risk actually accompanies the expectation of higher returns which may not actually materialize.

Note the word “expectation” – investors expect higher returns due to the higher perceived-risks in an investment, but the high return also has the probability of not showing up. In fact, there are cases where an investment has a high potential return coupled with low risk – such cases arise when a huge cloud of pessimism is factored into a company’s share price, and further bad news does not bring the share price down further.

Thinking about risk

The bottom line is that we all should try our best to think about and list down the risks pertaining to our investments. Risks may include (but are not limited to) liquidity risks, business expansion risks, regulatory and legal risks, and risks relating to a new product launch. I’m currently doing a deep dive into various aspects of risk in an article series that you can find here.

Once the investment risks are laid out, we will have a better notion of what kind of return to expect, and this prevents us from being overly-optimistic and sanguine. The relationship between risk and return is neither linear nor clear-cut, but we would be doing ourselves a great favour by at least considering the risks before investing, rather than ignoring them totally.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.