Risk and return are foundational concepts in investing. In general, investments that involve
higher levels of risk may offer higher potential returns, while lower-risk investments
typically provide more modest returns.
Risk refers to the possibility that an investment’s value may fluctuate or decline. Return
refers to the gain or loss generated by that investment over time. Understanding how these
two elements interact may help investors build portfolios aligned with their financial goals
and time horizons.
Download the Educational Resource Guide
This blog is based on the attached educational resource guide, Investment Strategy 101: Investment Horizon: Why It Matters, written by Larry Adam, who joined Raymond James in 2018 as Chief Investment Officer.
How Do Risk and Return Work Across Asset Classes?
Different types of investments fall along a spectrum of risk and potential return.
Cash Alternatives
Cash equivalents, such as short-term Treasury bills, are generally considered very low risk
and highly liquid. They are often used to meet immediate spending needs. However, their
returns have historically been lower compared to other asset classes.
Bonds
Bonds have typically offered higher yields than cash alternatives but introduce additional
risks. These may include interest rate risk and inflation risk. Bonds are often used to
address intermediate-term financial needs and may provide a balance between income
and stability.
Equities
Stocks generally represent the higher end of the risk spectrum. Equity markets can
experience significant volatility, including market corrections and bear markets, defined as
declines of 20 percent or more. However, over long periods, equities have historically
delivered stronger total returns than bonds or cash alternatives.
This range of outcomes illustrates the trade-off between stability and growth potential.
Why Does Investment Horizon Matter?
An investment horizon is the length of time an investor expects to keep money invested
before needing it.
Time horizon plays a central role in determining appropriate risk exposure.
For short-term needs, such as funds required within the next one to two years, lower-risk
investments may help preserve capital and maintain liquidity.
For intermediate-term goals, bonds have historically shown a high probability of positive
returns over rolling five-year periods, though results are not guaranteed.
For long-term goals, equities have historically demonstrated a higher likelihood of positive
performance over extended periods, such as ten years or more. While short-term volatility
may occur, longer time frames have generally improved the probability of positive
outcomes.
Matching investments to time horizon may help manage risk and set realistic expectations.
Key Risks and Considerations
Investors should be aware of several important considerations:
- Market Risk — Equity values may fluctuate significantly over short periods.
- Interest Rate Risk — Bond prices may decline when interest rates rise.
- Inflation Risk — Cash and fixed-income returns may not keep pace with rising
prices. - Liquidity Needs — Investing short-term funds in volatile assets may increase the
risk of loss if funds are needed unexpectedly. - Probability Is Not Certainty — Historical patterns do not guarantee future results.
Building Your Undestanding
Several related concepts are closely connected to risk, return, and investment horizon:
- Asset Allocation — Dividing investments among asset classes such as stocks, bonds, and cash.
- Market Volatility — The degree to which investment prices fluctuate over time.
- Total Return — The combined effect of income and price appreciation.
Understanding these principles may help investors make informed decisions about portfolio construction.
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What is the Contrarian View of Market Volatility?
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Frequently Asked Questions
What is the relationship between risk and return?
In general, investments with higher risk may offer higher potential returns, while lower-risk investments typically provide more modest returns.
What does risk mean in investing?
Risk refers to the possibility that an investment’s value may fluctuate or decline, potentially resulting in a loss.
What does return mean in investing?
Return is the gain or loss generated by an investment over time, including income and changes in value.
Are higher returns guaranteed with higher risk?
No. Higher risk may increase the potential for higher returns, but it also increases the possibility of losses. Outcomes are not guaranteed.
How does time horizon affect risk and return?
A longer time horizon may allow investors to take on more risk, as there may be more time to recover from short-term market fluctuations.
Why are stocks considered higher risk than bonds or cash?
Stocks tend to experience greater price volatility and can fluctuate significantly in value, while bonds and cash alternatives have historically been more stable but offer lower potential returns.
How can investors manage risk in a portfolio?
Investors may manage risk through diversification, asset allocation, and aligning investments with their goals and time horizon.
Is it possible to avoid risk completely when investing?
No. All investments carry some level of risk, including the risk of losing money or not keeping pace with inflation.
By
Educational Disclaimer
This content is provided for educational purposes only and is not intended as investment advice. Investors should consider their individual circumstances and consult appropriate professionals before making investment decisions.
