Tanzania: Decoding the Risk-Return Relationship

 By Jagjit Singh

Every investment transaction has two sides - Risk and Returns. As an investor you would always want

the higher return with lowest risk. Does it happen that way - let us decode it? Generally speaking, higher the potential return on an investment, the corresponding risk will be higher.

However, there is no guarantee that you will actually get a higher return by accepting more risk. Risk and returns are two sides of the investment coin. Risk is associated with the possibility of not realising return or realising less return than expected.

The degree of risk varies on the basis of the features of the assets, investment instruments, the mode of investment, the issuer of securities etc. Even the so called "risk free assets" like bank deposits also carry some element of risk, as there are many instances where a bank failed and deposits lost their money.

Thus, risk of an investment is the variance associated with its returns. The objective of risk management is not elimination of risk but proper assessment of the risk and deciding whether it is worth taking or not. While investing, most of us aspire to get "high return" but often ignoring the important element of "risk".

On investment matters return and risk always travel together. William Bernstein, in his famous book - 'The Four Pillars of Investing' has narrated this relationship quite vividly that - "the history of the stock and bond markets shows that risk and reward are inextricably intertwined. Do not expect high returns without high risk. Do not expect safety without correspondingly low returns".

The above message is hard but very loudly conveying a clear cut message that 'you can't have your cake and eat it too.' This saying is often used under varied circumstances, but when it is delivered on investment related matters the core meaning leads us to 'RiskReturn-Relationship'.

The risk-return relationship is directly proportional to each other, as higher the risk - higher the returns and conversely lower the risk - lower the returns.

Numerous investment research studies throughout the years have confirmed that the general investing public, or non-professional investors, have a pronounced tendency to focus on investment returns. While risk is not necessarily ignored, it certainly seems to play a second fiddle to returns in most individual investors' decision-making processes.

That being the case, there is an urgent need to explore the so called 'risk-return-relationship' for a better understanding. The relationship between risk and return is a fundamental financial relationship that affects expected rates of return on every existing asset investment.

The risk-return relationship is characterised as being a "positive" or "direct" relationship, meaning that if there are expectations of higher levels of risk associated with a particular investment then greater returns are required as compensation for that higher expected risk.

Alternatively, if an investment has relatively lower levels of expected risk then investors are satisfied with relatively lower returns. This risk-return relationship holds for individual investors as well as for business managers.

Irrespective of the situation, greater degrees of risk must be compensated for with greater returns. Since investment returns reflects the degree of risk involved with the investment, investors need to be able to determine how much of a return is appropriate for a given level of risk.

This process is referred to as "pricing the risk". In order to price the risk, we must first be able to measure the risk (or quantify the risk) and then we must be able to decide an appropriate price for the risk we are being asked to bear. So in simple terms and in layman's language, it is a universally accepted principle of investing that risk and return are commensurate.

This fancy terminology simply tells us that the level of risk determines the level of return. As a result, it is unusual that a low-risk investment will produce a high return. Of course, the inverse of this relationship is also true. Remember, risk is an inherent part of investing.

In order to get a reasonable return on an investment, risk has to be present. A risk free asset will produce little or no return. The intelligent investor manages risk by recognising its existence, measuring its degree in any given investment and realistically assessing his or her capacity to take risk.

There is nothing wrong with investing in a high-risk fund if the corresponding fund's return is equally high. The question to ask is: Can I afford the loss if it occurs? Am I emotionally prepared to deal with the uncertainties of high-risk investments? Do I need to take this kind of risk to achieve my investment goals? A prudent investor will seek to match and/or offset risk by diversifying his/ her portfolio and not putting all eggs in one basket. While doing so, one can find those that are characterised as having returns that exceed their risks, or at least match them.

This would represent a favourable risk-return profile, or spread, and is a key fund investment quality. So from herein, whenever you need to take any investment related decision, please do not concentrate on the returns part alone, as assessment of risk relating to that investment is equally important.

This is where it is important for every investor to clearly understand the "Risk-Return" relationship.