5 Investment Risks: Is Risk a Necessary Factor of Return?

Those of you who live in Arizona know that October is usually the month that the temperatures start decreasing and people are excited to be outside. I am one of those people. I live in Arizona for the opportunity to hike, bike and just enjoy the beautiful southwest outdoors.

Over the years, I have come to recognize the benefits, but also the hazards, associated with the different types of outdoor activities — and of simply being outdoors. Some of those benefits include: healthy workout, vitamin D, access to beautiful views.

In turn, some hazards associated with those benefits include: spraining an ankle while hiking, sunburn, running out of water. Knowing my desired outcome I am able to gauge my capacity for risk, and plan accordingly.

Risk and investment returns

This is also true with investments. One can get higher returns if they are willing to assume more risk and equally true, the lower their risk, the less they are expected to receive in returns. Historical data shows us that investors are compensated in proportion to the risk they take.

This research identifies five risk factors that explain most of the expected returns associated with different asset classes.

These asset classes are:

I. Stocks

  • Large Capitalization Companies: Growth/Blend/Value
  • Medium Capitalization Companies: Growth/Blend/Value
  • Small Capitalization Companies: Growth/Blend/Value

To differentiate and define risk within each stock asset class below are three factors:

        A. Market Risk —generally, stocks have higher expected returns than fixed income securities

       B. Size Risk—small capitalization stocks have higher expected returns than large company stocks

       C. Value/Growth Risk—lower-priced “value” stocks have higher expected returns than higher-priced “growth” stocks

II. Bonds

  • Long-Term (generally greater than 10 years): High to Low Credit Quality
  • Intermediate-Term (generally 4 to 10 years): High to Low Credit Quality
  • Short-Term (generally 1 to 3 years): High to Low Credit Quality

And then below reflect compensated risk in the bond market:

         A. Maturity Risk—longer-term bonds are riskier than shorter-term instruments

         B. Credit Risk—instruments of lower credit quality are riskier than instruments of higher credit quality

Assessing risk when making investment decisions

Just like we recognize the benefits and hazards associated with the outdoor activities we enjoy (risk/reward concept), we must also go through a similar process with investments. This risk/return concept is one of the essential components when making investment decisions and assessing a portfolio. My next blog, Managing Risk, will address the idea of managing and capitalizing on one’s exposure to risk factors.