Risk and return: the trade inside every return

What risk means in a return

In Moneysmart’s glossary, risk is the possibility that an investment falls in value or earns less than expected. Volatility is how much an asset’s return moves about over time: the more often the price moves, the higher the volatility and the greater the risk. Risk tolerance is how much uncertainty a person is prepared to accept, in particular how far they will sit through a negative return while aiming for positive ones.

Put in the language of the earlier exercises, risk is the chance that the rate in the sum is not the rate that turns up. A compound sum at a steady 3% has no risk in it because the rate is fixed by assumption; the investments this page describes do not fix it.

Two families of investment

Moneysmart sorts common investments into two groups.

Moneysmart attaches two cautions to that split. The time frames are only a rough guide: an investment held that long may still make no money, or never climb back from a fall. And “defensive” does not always mean the money can be withdrawn whenever it is needed.

The risks a return is exposed to

Moneysmart lists the risks that can change what an investment is worth. Three of them run through the sums and examples on this page:

• Market risk: something that shakes the whole market drags the investment’s value down with it, as in the 20% fall below.
• Concentration risk: with the money not spread out, one weak holding or asset class can pull the whole portfolio down; diversification, further on, is the answer Moneysmart describes.
• Inflation risk: the investment’s value falls behind rising prices, which is how cash loses ground later on this page.

The rest, from interest rate and currency risk to borrowing to invest, are set out on Moneysmart’s Develop an investing plan page.

The 20% question

Moneysmart suggests a test for risk tolerance: imagining waking up tomorrow to find the value of one’s investments had dropped 20%. If that would bring worry and a decision to withdraw, it says, high-risk investments are not a fit. The sum behind the question is less even than it looks.

A fall and a rise of the same size do not cancel. A 20% fall needs a 25% rise to recover, and the deeper the fall the wider the gap: a 50% fall needs a 100% rise, because the recovery is worked on the smaller balance. (This guide’s arithmetic.)

What spreading the money does

Diversification, in Moneysmart’s glossary, is spreading investments across different asset classes, or within one, to reduce risk. It reduces how much a whole portfolio’s value swings, because different types of assets do well at different times, so a loss in one may be offset by gains in another. Moneysmart describes four common ways to do it:

1. Across asset classes

   Shares, fixed income, property and cash. Moneysmart notes that shares have historically produced higher returns than the other traditional asset classes, with a higher chance of falling in any one year, while cash carries a very low risk of loss but loses buying power to inflation over time.

2. Within an asset class

   Shares in different industries or countries; bonds of different issuers and terms.

3. Across countries

   Australia has a small share of the world’s investment opportunities. Unhedged overseas assets add exchange rate risk, which can work either way.

4. Through funds

   A fund that holds many investments, or more than one fund manager, to rely less on one manager’s decisions.

A mix drifts. If shares rise while bonds fall, more of the portfolio ends up in shares and its overall risk is likely to rise; Moneysmart calls the adjustment back to the intended mix rebalancing, and notes that selling to rebalance may create a tax bill.