Risk-Takers Reap Rewards: Investing With Confidence

Investors who are risk-averse will seek out investments with minimal risk, while return is not a major consideration. However, they will take on additional investment risk if they are sufficiently compensated for this risk. This is known as a compensated risk, which, if taken, will increase the expected return of an investment portfolio. In contrast, an uncompensated risk is a risk that does not increase, and may even decrease, the expected return.

Compensated vs uncompensated risks

Risk-averse investors seek out investments with minimal risk, and return is not a major consideration. However, they will take on additional investment risk if they are sufficiently compensated for this risk. This is known as a compensated risk, which, if taken, will increase the expected return of an investment portfolio.

Compensated risks are contrasted with uncompensated risks, which do not increase the expected return of a portfolio and may even decrease it. For example, buying a single investment property or buying all properties in one geographic area are examples of uncompensated risk.

In general, investors need to be compensated for additional risk in the form of greater expected returns. Stocks, for example, are riskier than bonds but also have a higher expected return, known as the equity risk premium. Government bonds issued by developed economies are considered the safest investments and are sometimes referred to as risk-free.

US Treasury bonds are also considered one of the safest investments and provide a lower rate of return compared to corporate bonds.

Risk-averse investors

Compensated risks are distinct from uncompensated risks, which do not increase the expected return of an investment and may even decrease it. For example, buying a single investment property or buying all your properties in one geographic area are examples of uncompensated risk.

In general, investors need to be compensated for additional risk in the form of greater expected returns. Stocks, for instance, are riskier than bonds but also have a higher expected return, known as the equity risk premium. Government bonds issued by developed economies are considered the safest investments and are sometimes referred to as risk-free since a government has the option of printing more money to cover its debts.

A U.S. Treasury bond is another example of a safe investment that provides a lower rate of return when compared to a corporate bond. Investors who believe market prices are informationally efficient may invest in an index of risky assets that serves as a proxy for the market portfolio and allocate a portion of their investable assets to a risk-free asset.

The risk pyramid

Investors who are risk-averse will seek out investments with minimal risk, while return is not a major consideration. However, they will take on additional investment risk if they are sufficiently compensated for this risk.

The investment pyramid is an asset allocation strategy that investors use to diversify their portfolio investments according to the risk profile of each security. The pyramid structure should balance risk and reward based on an individual's time horizon, assets, and risk tolerance.

Risk-free investments

Risk-averse investors seek out investments with minimal risk, while return is not a major consideration. However, investors will take on additional investment risk if they are sufficiently compensated for this risk. In general, investors need to be compensated for additional risk in the form of greater expected returns. For example, stocks are riskier than bonds, but they also have a higher expected return, known as the equity risk premium.

There are some investments that are considered to be low-risk or even risk-free. Money market accounts, certificates of deposit, cash management accounts, and high-yield savings accounts all carry FDIC insurance. Treasury bills, notes, and bonds are backed by the US government, making them another low-risk investment option. Government bonds issued by developed economies are sometimes referred to as risk-free, as a government has the option of printing more money to cover its debts.

However, it's important to note that no investment is entirely risk-free. Even the most stable companies' stocks can fluctuate dramatically over short periods of time. Low-risk investments also tend to earn lower returns than riskier investments, and inflation can erode the purchasing power of money in low-risk investments.

Equity risk premium

Investors need to be compensated for taking on additional risk. This is known as the equity risk premium. The equity risk premium is the excess return that investing in the stock market provides over a risk-free rate. This excess return compensates investors for taking on the relatively higher risk of equity investing. The size of the premium varies and depends on the level of risk in a particular portfolio. It also changes over time as market risk fluctuates.

The formula for calculating the equity risk premium is equal to the difference between the expected market return and risk-free rate. Equity Risk Premium (ERP) = Expected Market Return (rm) – Risk Free Rate (rf). For example, if the estimated market return is 8% and the risk-free rate is 2%, the risk premium is 6%.

The equity risk premium and the level of risk are directly correlated. The higher the risk, the higher the gap between stock returns and the risk-free rate, and hence, a higher premium.

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