Apr 20, 2018 | BEN WAITE

Guiding Principle 2: Understand risk and return are related

You might already be familiar with PortfolioScience™, our evidence based investment approach. It’s built around these six principles of successful investing:

  1.   Accept the stock market is tough to beat
  2. Understand risk and return are related
  3. Don’t put all your eggs in one basket
  4. Focus on the investment mix (between growth and defensive assets)
  5. Keep your costs low
  6. Control your emotions and think long-term

Each month we’re blogging on one of these subjects in more detail, and here’s the second instalment:

Understand risk and return are related

To get higher returns, you need to take more risk. It means if an opportunity is advertising ‘guaranteed’ returns of 10%, you should start hearing alarm bells!

Spinning the wheel

Whilst we wouldn’t usually use gambling as an appropriate investment comparison, roulette is a great way to explain this point: if you chose to put all your money on black, you’d have almost a 50/50 chance (not quite because of the zero) of winning and doubling your money, or losing and ending up with nothing.

But if you want to win bigger, you have to increase the risk you take. So, you put your money on number 10. Now you could win 35 times your initial investment. But you also have a 35/36 chance of losing.

Putting your stake on an individual number, rather than a colour increases your chance of loss from 50% to 97%!

As to how this works for investors, we first need to understand the system that drives the global economy and its financial markets;

Capitalism

It’s where private owners like individuals, pension funds and trusts own and control assets purely for their own interests (or profit)! Supply and demand then efficiently sets prices.

If investors want to put their cash at risk in a capitalist system, they have two choices:

  1. Become a lender through a corporate or government bond, i.e. lending to companies or governments.
  2. Become an owner of an asset through owning shares in a company or by owning a property.

Lenders have a more certain future

That’s because you’re lending money out for a defined period of time, for an agreed interest rate. You know what the return will be and when you’ll get your money back.

As an owner, your return depends on factors outside of your control. There’s no guarantee that you’ll receive dividend or rental payments and you’re hoping that someone will purchase your asset in the future at a greater price than what you paid for it.

The more uncertain outlook of being an owner means you should expect a greater return; to be appropriately rewarded for the higher risk you’re taking.

A function of global financial markets working properly is that they price risk and reward fairly. Otherwise, there would be no point in investing!

Look at the long-term returns

This chart shows the returns of the UK stock market, government bonds and cash since 1976 through to the end of 2016:

£1 in 1976 held safely in cash would have turned into £16 by 2016.

If you’d taken slightly more risk and invested in government bonds, you’d have £21.

And if you’d invested in the UK stock market you’d have £131. Although you’d have had a much bumpier investment journey.

Risk and return are clearly related, if you want more returns, you have to take more risk – it’s as simple as that. When we’re constructing a portfolio for you we calculate how much risk you need to take, and can afford to take, as well as deciding how much risk you’re comfortable taking. This might sound complicated, but we find that actually it’s simple to make the right decisions about investing when they’re driven by a sound financial plan. To find out more, get in touch using the button at the top right of this page.

The value of investments and the income from them can go down as well as up, and you may get back less than you originally invested. Past performance is not a guide to the future. The investments described are not suitable for everyone. This content is not personalised investment advice, and Creaseys Wealth can take no responsibility for investment decisions you may make as a result of this information.

 

 

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