The Risk-Return Tradeoff

riskLet’s take a look at a fundamental and very important investment principle: the risk-return tradeoff.

The chart below shows a conceptual depiction of long term expected returns vs. risk (as measured by standard deviation of returns) for select asset classes.

Risk vs. Return Tradeoff For Individual Assets

Based on historical data over many years, studies show the relative risk-return levels of various asset classes. At any given time, an asset class can have very different go-forward risk-return levels vs. their historical averages. The problem is that no one can reliably and consistently predict what they will be, so history often serves as the best guide. Here are sample historical, inflation-adjusted, risk and return numbers:

Similarly, if you combine a mix of different asset classes in a portfolio, you will produce portfolios with different risk-return tradeoffs, depending on how much of each asset you place in the portfolio.

The higher the percentage of equities in a portfolio, the higher the returns and risk. In the past an investor could moderate risk while still earning good returns by adding bonds and/or Treasury Bills (very short term debt instruments) to arrive at their risk-return tradeoff sweet spot.

Allocation Effect on Risk-Return

By going with 100% stocks rather than a 60-40 stock/bond split, an investor earned an additional 2% per year of return but exposed themselves to an additional loss of 20% in the severe bear market of 1973-74.  This would be ok if the investor continued to hold 100% in stocks during the recovery. Unfortunately, most investors tend to sell during a bear market and miss the recovery, negating the benefits of long-term stock appreciation. This argues for holding less than 100% in stocks, so that investors can reduce losses and stay the course during severe market declines.

slide-69Modern portfolio theory created the concept of the “Efficient Frontier” which is the line where return is the highest for a given level of risk, as measured by the standard deviation of returns. This is depicted to the right.

You can learn more about the risk-return tradeoff and efficient frontier here.

A really nice depiction of the tradeoffs of various stock/bond mixes is provided by Vanguard here.

It turns out that the percentage of your portfolio allocated to equities (defined as stocks, equity mutual funds, private equity and REITs) is the major determinant of your portfolio’s risk of loss. That’s because they are a volatile asset class with the highest risk of loss.

Equities and Risk

What losses can you realistically withstand without abandoning your strategy? Do you sell your stocks in a severe bear market? What did you do in 2008? 2002? 1987?

So if you are building your portfolio or revisiting your overall investment strategy, I recommend you think about your risk tolerance. How much loss can you withstand and still sleep well at night? The table above serves as a rough guide.

Many investors think they can withstand higher losses until they actually experience them. That is a problem with taking the many risk assessment tests that are available from various sources. A better gauge is what you actually did in bear markets. The worst thing you can do is take more risk than you can tolerate and sell at or near the bottom, missing out on the inevitable rebound. See investing psychology.

In summary, the key concepts of risk-return are:

  1. Each asset class has a persistent level of risk and return relative to others over the long run.
  2. There is no free lunch. Higher returns require greater risk.
  3. The higher the percentage of equities in a portfolio, the higher the returns and risk.
  4. Every investor should make an honest assessment of how much risk they can take on, balancing their financial goals vs. their tolerance for losses.

Go to the Next Article: Asset Allocation