When people talk about risk vs. return, we usually hear that the higher the risk, the higher the return. Given that, it seems obvious to invest in the riskiest asset and get the highest return, right? Not quite.
In financial markets, risk is measured by an asset's volatility. Put very simply, it is how much an asset's price moves over time. Take the two hypothetical assets below:
| Day | Price of asset “A” | Price of asset “B” |
|---|---|---|
| 1 | 100 | 100 |
| 2 | 97 | 99 |
| 3 | 110 | 101 |
| 4 | 113 | 103 |
| 5 | 105 | 101 |
| 6 | 95 | 98 |
| 7 | 89 | 95 |
| 8 | 91 | 96 |
| 9 | 97 | 100 |
| 10 | 105 | 102 |
The example above is made up, and I chose the numbers to illustrate the point, but in real life you will find assets very similar to these.
Notice that asset “A” moved much more. It reached a high of 113 and a low of 89. Besides the price range of 24 (113 - 89), its day-to-day changes are very large in percentage terms compared with the other asset.
Asset “B”, on the other hand, moved much less, both in range and in daily changes. By the end of the period, asset A returned more than asset B, living up to the first paragraph of this post: higher risk, higher return.
The real face of risk
When we talk about risk in financial markets, we are talking about these daily price moves. The larger the daily moves, the higher the risk.
Again, although the numbers are made up, this is very close to what happens in real life. Just compare a stock with a fixed income bond. The stock's price tends to move much more than the bond's.
One point I want to make very clear: the phrase at the start of this post is quite imprecise. The more complete version is not "the higher the risk, the higher the return." It is: "the higher the risk, the bigger the possible gain or the bigger the possible loss."
That is because the world is not perfect. Imagine the investment in our example had ended not on day 10, as the table shows, but on day 7. The investor would have suffered a much larger loss on investment A than on investment B.
"So when you invest, always remember: the riskier asset does not give you a higher return. It gives you wider swings, in both directions."
As a result, the return, positive or negative, will be larger.
My goal is not to discourage you or push you toward low-risk assets only. It is to make clear what you, as an investor, are actually buying when you buy a riskier security. Always keep the asset's daily return swings in mind, and weigh your willingness to accept a potentially larger loss in exchange for a potentially larger gain.