Risk and return, two sides of the same coin

 

One of the first mistakes that I made as an investor was to focus exclusively on investment returns with little concern for investment risk. Risk and return are however two sides of the same coin and it is not a good idea to decouple them.

Risk means that the future actual return may vary from the return that you expect. The ultimate risk is off course completely loosing your investment.

If we look at the below screenshot - taken from the interesting course  Coursera - Introduction to Portfolio construction and Analysis with  Python - we see the monthly returns for  two financial assets (in orange and in blue). The mean return over the whole year for both assets is 1% but intuitively we  consider the orange asset to be more risky since it has a lot more variation on both the up and downside.

The definition of risk in financial literature is based on the variability of the actual return. Statistical measures of the variability are variance and the standard deviation (the square root of the variance). Standard volatility - also referred to as volatility - measures the variation from the average performance.

Since stocks are are a risky investment, you will typically want a return greater than the risk-free rate in order to be compensated for the risk you are taking. The risk free rate is a theoretical return of an investment with zero risk.  The interest rate on on a three-month U.S. Treasury bill is most often used by US based investors as a proxy for the risk-free rate of return (See 3-Month Treasury Bill Secondary Market Rate, Discount Basis (TB3MS) | FRED | St. Louis Fed for evolution of the three month U.S. Treasure Bill secondary market rate)

Two interest rate cycles immediately jump out of the graph:

1. The sharp spike in the early 1980s with rates above 15%, which coincides with the FED's aggressive fight against inflaction under Paul Volcker
2. Periods of near-zero rates (2009-1015 and 2020-2021) reflect responses to major economic crises - the Global Financial Crisis and the Covid 19 pandemic.

High interest rates favor fixed-income investments, while low rates push investors towards equities and riskier assets. The Treasury bill rates (peaking in July 2023) offer competitive returns with minimal risk for US nationals (foreign investors are still subject to exchange risk) and make them a viable alternative to savings accounts or money market funds.

References:

• Average risk free rate Germany from 2015 to 2021 (Statista)
• Euro short term rate 
• The Morningstar dictionary -  Sharpe Ratio