Risk and Reward

Investment risk is usually expressed in terms of volatility. The greater the volatility of investment returns, the greater chance you have of experiencing a loss. In other words, risk can be thought of as the potential for an investment to decrease in value.

Investors are generally risk-averse. In choosing between two investments with the same expected returns, most people prefer the less risky investment. Let’s consider government bonds, as an example. A bond is nothing more than a loan. When you buy a government bond, such as a U.S. treasury bill, you are loaning money to the government. According to the terms of the bond, the government agrees to repay your loan plus interest over a specified time period. U.S. treasury bills are backed by the full faith and credit of the U.S. government, which makes them virtually risk-free.

Companies also use bonds to raise money. If you buy a General Motors Corporation bond, you are loaning money to the company in return for a specified set of future payments. Although this is a low-risk investment (General Motors is unlikely to go out of business), it is not risk-free. Therefore, GM will have to pay a slightly higher rate of interest than the U.S. government when issuing bonds with similar characteristics. After all, why would you buy a GM bond if you could get a safer U.S. government bond that paid the same interest rate? When Amazon.com issued a large bond offering several years ago, they offered a much higher interest rate than GM or the U.S. government. Again, it was predicated on risk. Investors needed a higher rate of return to induce them take a chance on the riskier Amazon.com bonds.

The same concept applies to investing in stocks. Historically, investment returns from stocks have been more volatile (riskier) than returns from bonds. If stocks and bonds had the same expected returns, it would be hard to justify investing in stocks. Why expose yourself to greater risk without an expectation of greater rewards? However, stocks have outperformed bonds by a considerable margin in the past. From 1926 to 2000, the overall stock market had an average annual return of 11.2 percent compared to 5.7 percent for bonds. The expectation of similar results in the future is what keeps people in the stock market.

This relationship between risk and reward is fundamental to investing. As an individual investor, you need to find the appropriate balance of risk and expected return for your unique financial situation. If you have a high investment risk tolerance, you should be more comfortable having your money invested in stocks than someone with a low risk tolerance.

Unfortunately, we are not automatically rewarded for accepting risk. Academic studies have shown that you gain nothing by taking on company-specific risk. For example, if you put all of your money in Amazon.com stock, you are accepting a huge amount of unnecessary risk. This is referred to as company-specific risk because it relates to the fortunes of a single company. This risk can easily be avoided by investing in a diversified portfolio. The ability to eliminate company-specific risk through diversification has been referred to as "the only free lunch in economics."

There are two take-home messages here:

1. In order to increase your expected investment returns, you usually have to accept a higher level of risk.

2. Company-specific risk can be eliminated by holding a diversified portfolio.

Finally, please be aware of the greatest investment risk of all, which is the risk of doing nothing. Start planning your financial future today.

July 1, 2001

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