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Investing? What You Need to Understand About Risk-Return Levels

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In investing, like in life, the biggest rewards often go to those who take the biggest risks.

Investing is part art, part science, and it’s difficult to find the perfect investment — one that yields great returns with minimal risks.

One of the prevailing investment theories is Modern Portfolio Theory (MPT). MPT emerged in the 1950s and helps us determine the right risk and return level for different types of investors. It also helps investors who are averse to risk develop portfolios that can give them the best return with a certain amount of calculated risk.

However, following the principles of MPT is not as easy in practice. MPT assumes that most investors are rational decision-makers and can easily determine the appropriate risk-return tradeoff. Unfortunately, history proves this isn’t true — for evidence, just look at the 1990s tech bubble or the 2008 mortgage crisis that sent the country into a downward economic spiral.

One of MPT’s main purposes is to create an investment philosophy that instills a discipline to prevent such irrational decisions that destroys wealth. This discipline involves adhering to an investment policy statement that details an investor’s appetite for risk and the return that is reasonably expected. This risk-return profile is often depicted on a chart known as the “efficient frontier”. This chart shows an investor’s appropriate asset mix (70/30, 80/20, etc.) based on his or her risk profile: 

ICCFWF—Risk-Reward Efficiency 1

This chart is effective in relating the relationship between risk and return, but falls short in developing a truly diversified portfolio. A mix of 70/30 stocks/bonds is essentially a 30,000-foot view. An investor needs to diversify further within the asset classes. Companies are found worldwide and in different sizes. Commodities are priced differently from the companies that produce them and not all bonds are created equal. Look at the asset returns on the chart below and ask yourself if you think emerging markets are too risky for you.

 


ICCFWM—Risk-Reward Efficiency 2
Diversification and asset allocation are key for investors to maximize their rewards, and to do this there needs to be some level of risk. Relying on market averages will only get you so far, but talk to your financial advisor or portfolio manager to gauge what level of risk you’re comfortable with. This may change as you age — with more risky investments in your 30s and early 40s and more conservative ones as you near retirement. Research has shown that doing this rebalancing is critical to lowering your investment risk over time. However, as an investor, you should do so strategically. You can’t outwit the market, but you can make decisions based on risk-return levels that puts your portfolio in the best position to grow.

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