Risk and return

Risk is a complex topic. There are many types of risk, and many ways to evaluate and measure risk. However, when it comes to investing, risk can be summarized simply as follows:

Even though this definition of risk sounds simple, questions arise:
 * “Risk is the uncertainty that an investment will earn its expected rate of return.”


 * How is uncertainty of returns (risk) evaluated and measured for different types of investments?
 * What is "expected rate of return", and how is it evaluated?
 * What can be done to manage risk?
 * How does an investor factor risk into investment decisions?
 * Are there differences between short-term risk and long-term risk?
 * The definition above does not distinguish between positive and negative outcomes. Isn't risk just the possibility that the investor will lose money on the investment?

To make wise investment decisions, an investor must spend some time studying the answers to these questions.

Risk and return, an inseparable pair


Selecting the percentage of stocks and bonds in your portfolio (asset allocation) is one of the most important investing decisions an investor can make. Underlying this decision is a desire to control risk. Why does selecting a bond versus a stock influence risk? It all boils down to how stable the returns will be over time.

First, past performance does not predict future performance. However, we can use historical data to show why one might prefer stocks over bonds or vice-versa. Refer to the figure on the left, which looks at past returns from 1928 to 2011. These are statistical charts which show how many times the U.S. stock market and U.S. Treasury bills and bonds gave a certain return.

Refer to Figure 1. The top chart shows returns for U.S. Treasury bills (T-Bill), short term instruments (90 days) that are very certain of giving positive returns, as evidenced by all 84 years of data. The tallest bar shows that annual returns (horizontal axis) on 3-month T-Bills have fallen in the range of 0% to 5% in 59 years (vertical axis). Returns have been between 0% and 10% in most years (tallest two bars), and between 0% and 15% in all years (all three bars).

This demonstrates that there is very high certainty in the return that will be earned on an investment in a 90-day Treasury bill (T-Bill) or short-term Certificate of Deposit (CD). Similarly, there is fairly high certainty in the return that will be earned over a short period in a money market fund. Even over longer time periods, the returns earned by money market securities fall into a relatively narrow range.

T-Bills and CDs are among the investments referred to collectively as money market securities. For an individual investor, a federally-insured bank account also provides a high degree of certainty in the short-term return. 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.

The middle chart in Figure 1 shows the range of annual returns on 10-Year Treasury Bonds from 1928 through 2011. Over this same period of time, the majority of years provided investors with positive returns, but a few were negative. Note the larger range (dispersion) of returns--from about -11% to +33%.

Finally, the bottom chart is the performance of the U.S. stock market (S&P 500), which shows the range of annual returns from 1928 through 2011. Note the much wider range (larger dispersion) of returns --from about -44% to +53%. It's hard to tell what the stock market will do from one year to the next.

Compared to money market securities (CDs and short-term securities), 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.

Investors are risk averse. Therefore, they demand a higher expected return for riskier assets. This demonstrates one of the most fundamental axioms of investing: ''Risk and return are inextricably related. Higher returns can only be achieved by taking more risk, but because the risk exists, the higher expected returns may not be realized.''

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. 