Central to any discussion about successful investment is an understanding of risk and return. It is a prudent notion that the higher the risk the greater the return that an investor should require before being tempted to invest.
It is my experience however that there is relatively little consideration given by the average investor as to why a good return is being offered - there is much more emphasis on getting the high return itself.
I have seen retired investors with a large proportion of their life savings in one investment chosen specifically for its high returns relative to the market without any consideration being given to why the returns offered are so good (an example historically being finance company investments).
An investor should have an understanding of the risks involved in a particular investment before making a decision to invest.
Risk is the chance that an investment outcome will be different from that expected - that the investment will reduce in value or indeed that the capital will be lost.
A study conducted in the United States clearly highlights the relationship between risk and return in their markets between 1926 and 1987.
The return shown is after inflation has been deducted. The variation (1yr +/-) is the potential movement in returns up or down that occurred in any one year during the 60-year period of the study.
Small company shares had an 8.8% return but with a potential variance of 35.2% in any one year. The share market generally returned 6.6% with a variance of 21.2%. Long term fixed interest was 1.5% with a variance of 10.2% and short-term fixed interest 0.4% with a variance of 4.4%.
Clearly shares produced the greatest return over the sixty-year period but they also had the largest variation in returns over shorter periods - the greatest risk (volatility) as we have defined it.
The cash and fixed interest returns reflect that this type of investment has struggled to exceed the inflation rate over longer periods.
The message is not that risk is a bad thing that should be avoided. Rather the message is that risk and its relationship to return should be understood so that informed choices can be made.
The clear lesson from the Table above is, and it is supported by other evidence, that over longer time periods investors have been rewarded for taking on additional risk.
And having understood the risks the perfect investment is one that allows the investor to meet his objectives and be rewarded for that risk but still leaves him sleeping soundly at night.
