CFM: Risk and return

Risk–return spectrum

The risk–return spectrum (also called the risk–return tradeoff) is the relationship between the amount of return gained on an investment and the amount of risk undertaken in that investment. The more return sought, the more risk that must be undertaken.

There are various classes of possible investments, each with their own positions on the overall risk-return spectrum. The general progression is: short-term debt; long-term debt; property; high-yield debt; equity. There is considerable overlap of the ranges for each investment class.

All this can be visualised by plotting expected return on the vertical axis against risk (represented by standard deviation upon that expected return) on the horizontal axis. This line starts at the risk-free rate and rises as risk rises. The line will tend to be straight, and will be straight at equilibrium - see domination.

For any particular investment type, the line drawn from the risk-free rate on the vertical axis to the risk-return point for that investment has a slope called the Sharpe ratio.

The existence of risk causes the need to incur a number of expenses. For example, the more risky the investment the more time and effort is usually required to obtain information about it and monitor its progress. For another, the importance of a loss of X amount of value is greater than the importance of a gain of X amount of value, so a riskier investment will attract a higher risk premium even if the forecast return is the same as upon a less risky investment. Risk is therefore something that must be compensated for, and the more risk the more compensation required.

If an investment had a high return with low risk, eventually everyone would want to invest there. That action would drive down the actual rate of return achieved, until it reached the rate of return the market deems commensurate with the level of risk. Similarly, if an investment had a low return with high risk, all the present investors would want to leave that investment, which would then increase the actual return until again it reached the rate of return the market deems commensurate with the level of risk. That part of total returns which sets this appropriate level is called the risk premium.

The use of leverage can extend the progression out even further. Examples of this include borrowing funds to invest in equities, or use of derivatives.

If leverage is used then there are two lines instead of one. This is because although one can invest at the risk-free rate, one can only borrow at an interest rate according to one's own credit-rating. This is visualised by the new line starting at the point of the riskiest unleveraged investment (equities) and rising at a lower slope than the original line. If this new line were traced back to the vertical axis of zero risk, it will cross it at the borrowing rate.