Risk and return: an introduction

Risk is a complex topic. There are many types of risk, and many ways to evaluate and measure risk. In the theory and practice of investing, a widely used definition of risk is:


 * “Risk is the uncertainty that an investment will earn its expected rate of return.”

Note that this definition does not distinguish between loss and gain. At first this may seem strange, since typical individual investors think of risk as the possibility that their investments could lose money. They are likely to be quite happy with an investment return that is greater than expected (a “positive surprise”). However, since risky assets generate positive surprises as well as negative surprises, defining risk as the ‘’’uncertainty’’’ of the return is reasonable (“return” is short for “rate of return”).

In financial planning, the investment goal must be considered in defining risk. If the goal of the investment portfolio is to pay for living expenses in retirement, then a very real risk is the possibility that the investor will outlive the investment portfolio. This is an example of ‘’shortfall risk’’. An investment portfolio may be constructed to generate an expected rate of return that is sufficient to meet the investment goal, but because there is uncertainty that the portfolio will earn its expected rate of return, the realized return may fall short of the expected return (“expected return” is short for “expected rate of return”). Thus, the concept of investment risk as the uncertainty of investment returns is not inconsistent with the concept of shortfall risk.

Risk as the uncertainty of returns
The uncertainty inherent in investing is demonstrated by the historical distributions of returns of three major asset classes: cash, bonds, and stocks.

The term cash often is used to refer to money market securities and money in bank accounts. Vanguard refers to these types of assets as short-term reserves. There is very high certainty in the return that will be earned on an investment in money market securities such as Treasury bills (T-Bills) or short-term certificates of deposit (CDs). Similarly, there is fairly high certainty in the return that will be earned over a short period in a money market fund. Money market fund holdings consist of T-Bills, CDs, and other money market securities.

For an individual investor, a federally-insured bank account also provides a high degree of certainty in the short-term return.

Even over longer time periods, the returns earned by money market securities fall into a relatively narrow range.

The annual returns on 3-month T-Bills (representing "cash") have fallen in the range of 0% to 15% during the 84 year period from 1928 through 2011. This range of returns is represented in Figure 1 by the vertical bar on the far left (above the label "U.S. Treasury Bills). Also note the tick mark showing the average annual return of 4%.

As the chart indicates, the return on bonds is less certain, and the return on stocks is even more uncertain. Thus, bonds are considered riskier than money market securities (cash), and stocks are considered riskier than bonds.

Figure 1 shows the range of annual returns on 10-Year Treasury Bonds from 1928 through 2011. Bonds have displayed a larger range (dispersion) of returns--from about -11% to +33%, with an average 5% annual return.

Figure 1 also shows the range of annual returns on stocks in the S&P 500 from 1928 through 2011. Note the much larger dispersion of returns--from about -44% to +53%, and an average 11% annual return.



Relationship between risk and return
Investors are risk averse; i.e., given the same expected return, they will choose the investment for which that return is more certain. Therefore, investors demand a higher expected return for riskier assets. Note that a higher expected return does not guarantee a higher realized return. Because by definition returns on risky assets are uncertain, an investment may not earn its expected return.

Although the charts in Figure 1 show historical (realized) returns rather than expected (future) returns, they are useful to demonstrate the relationship between risk and return. Note that the mean (average) annual return increases as the dispersion of returns increases.

This demonstrates one of the most fundamental axioms of investing: ''Risk and return are inextricably related. Higher returns generally can be achieved only by taking more risk, but because the risk exists, the higher expected returns may not result in higher realized returns.''

If inflation is considered, even money market securities have some risk, in that they may not achieve the expected real (inflation-adjusted) return. Unexpected inflation may reduce the real return below the expected return of the money market investment.

Uncertainty in real returns can be eliminated by investing in inflation-indexed securities, such as Treasury Inflation Protected Securities (TIPS) and Series I Savings Bonds (I Bonds). Of course in return for this reduction in uncertainty, investors must accept lower expected returns. Even inflation-linked securities have risks; e.g., TIPS have interest-rate risk, re-investment risk, and liquidity risk. No investment is truly risk free.

Diversification
Risk can be reduced through diversification.

The risk of investing in a single risky security, such as a stock or corporate bond, is very high due to the company-specific risks. Any number of unfortunate events could occur that could impact the rate of return. In the worst possible case, the company could go bankrupt, and the investor could lose the entire value of the investment. Company-specific risk is generally referred to as unsystematic risk or nonsystematic risk. Other names are unique-risk, firm-specific risk, or diversifiable risk.

Unsystematic risk can be eliminated by holding a broad portfolio of risky assets; e.g., many different securities in many different industries. This can be accomplished effectively by owning a total market stock or bond index fund. Unsystematic risk is risk that can be "diversified away".

The risk that remains in a portfolio after diversifying away unsystematic is referred to as systematic risk. Other names are market risk or nondiversifiable risk. A total stock or bond market fund has systematic risk.

Asset allocation
main article: Asset Allocation

After diversification, the next step in managing portfolio risk is asset allocation.

In theory, asset allocation is the process of selecting an appropriate mixture of risk-free assets and risky assets. Optimally, the risky portion of the portfolio includes all risky assets; e.g., stocks, bonds, real estate, etc. A 30-day T-Bill is most commonly used to represent the risk-free asset.

In practice, short-term, high quality bonds are considered to be relatively risk free, and so are typically considered part of the (relatively) risk-free portion of the portfolio. Although a bond fund that includes riskier bonds (e.g., corporate bonds and bonds with longer maturities) is technically a risky asset, the risk is low in comparison to stocks. In the context of investing according to the Bogleheads® investment philosophy, broad-based, short- to intermediate-term bond funds often are used for the low-risk portion of the portfolio, and broad-based stock funds are considered to comprise the risky portion of the portfolio.

Selecting the appropriate asset allocation (ratio of risky assets to low-risk assets) is essential to designing a portfolio that matches the investor's ability, willingness, and need to take risk. . Asset allocation is one of the most important decisions that investors can make. In other words, the importance of an investor's selection of individual securities is insignificant compared to the way the investor allocates their assets to stocks, bonds, and cash equivalents.

Specific types of risk
Below are descriptions of different types of investment risks.

Portfolio theory makes an important distinction between two types of risks:


 * Unsystematic risk: the measure of risk associated with a particular security; also known as diversifiable risk. This risk can be mitigated by holding a diversified portfolio of many different stocks in many different industries.
 * Systematic risk: also known as market risk. Systematic risk is faced by all investors due to market volatility. This risk can not be diversified away. This is the type of risk most people are referring to when they casually use the term "risk" with respect to investments.

Some additional risks faced by all investments include:


 * Liquidity risk--the risk that an asset cannot be sold when desired or in sufficient quantities because opportunities are limited. Treasury securities (with the exception of inflation protected Treasury bonds) have the least liquidity risk.
 * Political risk--the risk to an investment due to changes in the law or political regime. Potential changes in tax law or changes in a country's structure of governance are sources of political risk.

Stocks, bonds and cash are all subject to inflation risk--the risk that one's investment will not keep pace with inflation. This risk can be mitigated by investing in inflation protected Treasury bonds.

Stocks and corporate bonds are subject to financial risk--the risk due to the capital structure of a firm. Corporate debt magnifies financial risk to a company's stocks and bonds.

Bond investors also face the following major risks:


 * Interest rate risk--the risk associated with changes in asset price due to changes in interest rate. Bonds and bond funds face this type of risk. As interest rates rise, prices on existing bonds decline and vice versa. Interest rate risk is greater for bonds with longer maturities, and lower for bonds having short maturities.
 * Credit risk--the risk of default. Holders of corporate and municipal bonds face this risk.

Other risks applicable to bond investments include:


 * Call risk--the risk that a bond issuer, after a decline in interest rates, may redeem a bond early, forcing the bond holder to find a replacement investment that may not pay as well as the original bond.
 * Reinvestment risk--the risk that earnings from current investments will not be reinvested at the same rate of return as current investment yields. Coupon payments from a bond may suffer reinvestment risk if they cannot be reinvested at the same rate as the bond's yield.

Investors in international stocks and bonds are also exposed to currency risk, the risk due to changes in exchange rates. Investments in currencies other than the one in which the investor purchases most goods and services are subject to currency risk.

Investors using actively managed funds are exposed to management risk--the risk that fund or portfolio managers will under-perform benchmarks due to their management decisions or style. Investors can avoid this risk by selecting passively managed index funds.

Individual investors are exposed to two additional risks:


 * Shortfall risk--the risk the portfolio will not provide sufficient returns to meet the investor's goal(s).


 * Shortfall risk is one of the most significant risks investors face.


 * Longevity risk--the risk an investor will outlive his/her money.