Rational investors want the highest possible return for a given level of risk. The higher the risk, the higher the return investors demand. And, for the same level of return, investors choose less risky investments.
It is evident by comparing United States government bonds (Treasuries) to bonds issued by corporations. Since the American government guarantees repayment of principal invested plus interest on these bonds, the U.S. Treasuries are considered safe.
On the other hand, corporate bonds are considered to be riskier as corporations can’t provide the same assurance as the American government. Therefore, investors demand compensation for increased risk in the form of higher interest rate for Corporates in comparison to Treasuries.
Standard deviation and risk
The risk of a financial instrument is measured in standard deviation. That’s quite an important concept in finance, which all investors need to understand. It measures the spread of values, which are fluctuations in prices, both negative and positive.
According to this concept, 68% of values lie within one standard deviation, 95% within two standard deviations, and nearly all, 99.73%, within three standard deviations.
Volatility of investments can be estimated by calculating their standard deviation for a period of one year, or longer. (By the way, this is historical volatility based on which the future probabilities of return are estimated.)
To give an example, if a security, such as Stock A, has a standard deviation of 10%, it means there is a 68% chance (one standard deviation) that it will fluctuate +/- 10%.
Now, let’s take two standard deviations for a higher probability estimation of stock’s volatility. According to this, there is a 95% probability Stock A will fluctuate +/- 20%. If the price of this stock is $50, it may go down 20% ($10) to $40, or it may rise to $60. This is based on this high probability, but still there is no guarantee as to the future return.
Now, imagine that Stock B has a standard deviation of 15%. So, there is a 95% chance (two standard deviations) that its price may rise or fall 30%. What if it falls 30%? That makes it riskier than the previous example (Stock A) where two standard deviations would mean a drop of 20%.
Therefore, higher standard deviation makes investments riskier. Higher risk has potential for bigger profit, but also for bigger loss. Therefore, investors will buy a riskier security only if it offers better return potential than a security that is less risky.
Risk among asset classes
Different stocks have different standard deviations (risks), and these can also change over time. In addition, different asset classes have different risks. Generally speaking, stocks are riskier than bonds (although there are stocks that are less risky than some bonds, especially high yield junk bonds).
But, to make a generalization here, stock investors demand higher returns than bond investors as risk is higher. Effectively, over the decades, stocks as an asset class have produced higher returns than bonds, but also stocks had more down periods.
On the top of the risk scale you’ll find futures, options, and other investments such as art and collectibles. These are followed by stocks. After stocks, mutual funds come since these have lower risk because stock funds are less risky than individual stocks because their portfolios are diversified. Next, come corporate and municipal bonds, high yield bonds (bonds issued by entities who don’t have a good credit rating, thus pay higher interest rates), and real estate. Then, at the bottom of the risk scale, we have U.S. Treasuries, Certificates of Deposit, insured bank deposits, and money market funds.
In summary, the higher the risk, the more investors demand in future return. Usually, a value of an investment will fall when its risk rises. If you don’t like risk, than you need to settle for smaller returns. As the saying goes, “There is no free lunch on Wall Street.”
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