The Relationship between Risk and Return

Risk is an inherent part of investing. Generally, investors must take greater risks to achieve greater returns, however taking on additional risk does not always lead to greater returns. Investors who take on additional risk, must be comfortable with experiencing significant periods of underperformance in the expectation of achieving higher returns over the longer term. Those who do not bear risk very well have a relatively smaller chance of making high earnings than do those with a higher tolerance for risk; similarly they have a smaller chance of making significant losses. It's crucial to understand that there is an inevitable trade off between investment performance and risk. Higher returns are associated with higher risks of price fluctuations.

It is important to establish your attitude to risk before you begin investing.  Is the security of your capital the overriding influence in your investment decisions or are you willing to tolerate the ups and downs of the market in the expectation of higher returns?

Although not always the case, generally speaking, the level of return on your investments will reflect the underlying risk. If you’re only willing to accept low or zero levels of uncertainty, your investment returns are also likely to be low. However, an investment that seems very attractive in terms of its potential return may not be the right choice if it carries an unacceptably high risk. High risk investments generally require that the investor has the ability to hold it for the longer term (5-10 years), in order to allow shorter term performance issues time to resolve themselves. Importantly, investors should remember however that accepting high levels of risk does not always result in high returns.

Not all investment decisions will turn out as expected, but diversification can be a key tool in managing risk. By acquiring a portfolio of varied investments across a range of asset classes (shares, bonds, cash, etc), geographies and sectors, investors can minimise the effects which poorly performing investments can have on their overall portfolio. This diversification theory applies within asset classes as much as at portfolio level.

There are specific risks which investors should be aware of when investing in certain asset classes. The following sections deal with some of the risks which apply when investing in shares.

Risks of investing in shares

The Risk of Capital Loss

When a company is performing poorly or when the market perception of the company is negative, the share price may fall below the price which you originally paid for the share or even to zero. If a company goes out of business, its shares will become untradeable and it is likely to be delisted. Where a liquidator is appointed, shareholders are last in the list of other creditors (eg Banks, suppliers, etc) to receive any funds that may be realised.

Volatility Risk

Share prices can be very volatile and investors should be aware that their shares may fluctuate significantly in price in short periods. This can apply to individual stocks, sectors or to the market itself.

Market risk

This is the chance that the entire market will decline, thus affecting the prices and values of securities. Market risk, in turn, is influenced by outside factors such as interest rate changes.

Sector Specific Risk

This is the risk that a particular sector experiences malaise, eg the airlines industry on news of terrorist attacks.  Such periods of weakness can however provide buying opportunities, but existing investors must decide whether they are prepared to weather the storm or whether they should sell their shares in anticipation of further declines.

Stock Specific Risk

Similar to sector specific risk, this is the risk that a particular investment will experience share price declines due to negative news flow or poor sentiment towards the company. This would usually follow a weak trading statement or perhaps a change in management which is not well perceived by the market.

Timing Risk

This is the risk that you buy or sell a share at the wrong time. Not all sectors of the market follow the same price cycles. Understanding business cycles and how different companies perform during different phases of the business cycle can help to manage the effects of timing risk.

Exchange Rate Risk

This is the risk that investments in a foreign currency lose value when converted to your local currency, due to movements in the exchange rates between the two currencies.

These are just some of the risks that are associated with an investment in the stockmarket. Individual shares will have their own individual risks. It is critical that investors understand the effect that these risks can have on their investments. Further information is available from Davy Select on request.