Investment Risk versus Investment Return

Investment Risk

To understand investment risk it is easiest to consider some of the most popular investments. Money Market Investments (GIC) or Government Bonds (loans) are the least risky investments since they are backed by the Bank or by the Government and there has never been a widespread default.

Corporate bonds are more risky since they are issued by individual companies and there have been company failures, making the bonds completely worthless or at least much less valuable than what was invested. Even if they don’t fail completely bond prices do move up and down, which also creates risk for the investor

Finally, stocks are most risky since stock prices can move up and down quite dramatically. Movements down tend to be most memorable since they make the news and can happen very quickly (movements up tend to happen more gradually). The last big drops happened in 2001 (burst of the dot.com bubble) and 2008 (financial crisis).

So, in terms of risk overall, stocks are the most risky since you have the biggest chance of losing some or all of your investment. Money Market Investments and Government Bonds are the least risky since there has never been a major default in Canada or in any major developed market.

Investment Return

With risk comes return and returns increase as risk increases.

Stocks have consistently delivered superior returns over the long term, followed by bonds and then by money market funds. Taking the data from the US, from 1802 to 2011, stocks delivered real returns of 6.7% (adjusted for inflation) while bonds delivered 3.5% return and money market and government bonds delivered around 2.7% return

So, if Stocks return almost double the next best investment (Bonds), why not put 100% of your investments in stocks. The reason can be found by shortening the time horizon.  For example, if you made an investment just before the last two stock market crashes (in 2001 and 2008), you would have lost a lot money in the stock market but would be fine holding government bonds or GICs

The point is that higher risk investments produce higher returns but only over the long term. So your choice of investments must be made considering your investment horizon and your risk tolerance.