Raleigh NC Financial Advisor: Risks and Returns
Risk and return are, effectively, two sides of the same coin. In an efficient market, higher risks correlate with stronger potential returns. At the same time, lower returns correlate with safer (lower risk) investments.
Together these concepts define how investors choose their assets in the marketplace, and they define how investors set asset prices. Let’s break down how this relationship affects your investments.
Risk vs Return
In the context of the stock market, risk refers to the potential for loss of investment value. This can occur due to a variety of factors such as economic downturns, company-specific issues, and market volatility. The greater the risk associated with an investment, the higher the potential for loss.
Return, on the other hand, refers to the profit or gain that an investor receives from their investment. In the stock market, returns can come in the form of capital appreciation (an increase in the value of the stock), dividends (a portion of the company's profits paid out to shareholders), or both.
Generally speaking, there is a direct relationship between risk and return in the stock market. Stocks with higher risk tend to offer the potential for higher returns, while stocks with lower risk typically offer lower returns. This relationship is often referred to as the risk-return tradeoff.
Investors should carefully consider their risk tolerance and investment goals when choosing stocks to invest in. High-risk investments can be attractive for investors seeking high returns, but they may also be more volatile and subject to significant fluctuations in value. Conversely, low-risk investments may offer more stability, but may also have limited growth potential.
Risk-Return Tradeoff
Virtually all investments carry some degree of risk, though some are riskier than others. For example, stocks are generally considered to be much riskier than bonds because they’re more susceptible to market volatility. Understanding differences in risk is central to understanding how the risk return tradeoff works.
In simple terms, the more risk an investor is willing to take on, the greater the likelihood of generating higher returns from an investment. So an investor who chooses to concentrate 90% of their portfolio on stocks and 10% on bonds may realize higher returns compared to an investor who only holds 40% of their portfolio in stocks and 60% in bonds.
The tradeoff the first investor makes is accepting a greater possibility of losing money in order to realize higher returns. Meanwhile, the second investor is making a different kind of tradeoff. By concentrating less of their holdings in stocks, they’re exchanging the potential for higher returns for more stability with fixed-income investments.
Does Low-Risk Mean Low Returns?
Generally, lower risk investments in the stock market may be associated with lower returns compared to higher risk investments. This is because investors require compensation for taking on additional risk, and will only invest in lower risk assets if they expect a lower but more stable return.
For example, stocks of established companies with a long history of stable earnings and low volatility are generally considered to be lower risk investments. However, these stocks may also have lower potential for growth and offer lower returns compared to newer companies with higher growth potential but also higher risk.
That being said, there is no one-size-fits-all answer to this question as risk and return can vary widely among different stocks and investment strategies. Additionally, past performance is not necessarily indicative of future results, and investors should always do their own research and consider their individual investment goals and risk tolerance before making any investment decisions.
Does High-Risk Mean High Returns?
Investing in high-risk stocks in the stock market can potentially lead to higher returns, but it is not guaranteed. High-risk stocks generally have a greater potential for price fluctuations and higher volatility, which can lead to greater losses or gains for investors.
However, it is important to note that investing in high-risk stocks is not suitable for everyone. Such investments carry a higher degree of uncertainty and the potential for significant losses, which can be difficult to handle for some investors. Moreover, high-risk investments may require a long-term investment horizon and a higher level of monitoring and research.
Furthermore, while some high-risk stocks may experience significant growth in the short term, they may also experience significant losses if the underlying company's earnings or performance fail to meet market expectations. Therefore, it is important for investors to assess their own risk tolerance and investment goals before making any investment decisions, and to conduct thorough research before investing in any high-risk stocks.
Examples of Low-Risk Stocks
Some examples of low-risk investments in the stock market are:
Blue-chip stocks: These are stocks of well-established, financially stable companies that have a long history of profitability and growth. Examples of blue-chip stocks include companies like Coca-Cola, Procter & Gamble, and Johnson & Johnson.
Dividend-paying stocks: These are stocks of companies that pay regular dividends to their shareholders. Dividends are a portion of a company's profits that are distributed to shareholders, and these stocks can provide a reliable source of income for investors. Examples of dividend-paying stocks include companies like ExxonMobil and AT&T.
Index funds: These are mutual funds or exchange-traded funds (ETFs) that track a market index, such as the S&P 500. These funds provide exposure to a broad range of stocks and can offer diversification and stability in a portfolio.
Utility stocks: These are stocks of companies that provide essential services, such as electricity, gas, and water. Utility stocks are often considered a defensive investment because they tend to be less affected by economic cycles and market fluctuations.
Government bonds: These are debt securities issued by a government, which pay a fixed rate of interest and provide a low-risk investment option. While government bonds are generally considered to be low-risk investments, they may be subject to interest rate and inflation risk.
It is important to note that while these investments are generally considered to be low-risk, they are not completely risk-free and can still be subject to fluctuations in the market.
Examples of High-Risk Stocks
Some examples of high-risk investments in the stock market are:
Small-cap stocks: These are stocks of companies with a smaller market capitalization and less established track record than blue-chip stocks. Small-cap stocks are often associated with higher volatility and greater risk of failure than larger, more established companies.
Technology stocks: Technology companies can offer high growth potential, but also tend to be subject to rapid technological change and intense competition, which can result in significant price fluctuations.
Emerging market stocks: These are stocks of companies based in developing countries, which may be subject to greater political, economic, and currency risks than companies based in more stable economies.
Biotech and pharmaceutical stocks: These stocks can be subject to significant fluctuations in value due to the high degree of uncertainty associated with the success or failure of drug development, clinical trials, and regulatory approvals.
Leveraged ETFs: Leveraged ETFs are exchange-traded funds that use borrowed funds to amplify returns. While these funds can offer the potential for high returns, they can also be subject to significant losses in volatile markets.
It is important to note that high-risk investments can be unpredictable and often require a long-term investment horizon and a higher level of monitoring and research.
Investors should always assess their individual risk tolerance and investment goals before making any investment decisions. Investors should also seek advice from a financial advisor or financial planner if needed.
Bottom Line
The bottom line is that all investments carry some degree of risk. By better understanding the nature of risk, and taking steps to manage those risks, you put yourself in a better position to meet your financial goals.
Understanding risk return tradeoff can help with making investment decisions. For example, if you’re seeking higher returns then you know that you’ll probably need to take more risk. And if you prefer to invest more conservatively, you also know that it could mean realizing a lower level of return.
Just keep in mind that results are not guaranteed so creating an investment portfolio that’s properly diversified can help with managing risk. As always, you should consult your financial advisor or financial planner to help you reach your financial goals.
Sources
https://austenmorris.com/high-risk-vs-low-risk-investment/
https://smartasset.com/investing/risk-return-tradeoff
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Inverse/Leveraged ETF
Leveraged and inverse exchange traded funds ("ETFs") are for sophisticated investors who understand their risks including the effect of daily compounding of leveraged investment results and for accounts that will be actively monitored and managed on a daily basis. These products require an Aggressive Growth Investment Objective and a High Rick stated risk tolerance on an executed Confidential Investor Profile to purchase. The more an ETF invests in leveraged instruments, the more the leverage will magnify any gains or losses on those investments. Inverse ETFs involve certain risks, which include increased volatility due to the ETF's possible use of short sales of securities and derivatives, such as options and futures. The ETF's use of derivatives, such as futures, options and swap agreements, may expose the ETF's shareholders to additional risks that they would not be subject to if they invested directly in the securities underlying those derivatives. Short-selling involves increased risks and costs. You risk paying more for a security than you received from its sale. Leveraged and inverse ETFs seek to provide investment results that match the performance of a specific benchmark, before fees and expenses, on a daily basis. Inverse ETFs should lose money when their benchmarks or indexes rise - a result that is opposite from traditional ETFs. ETFs are non-diversified investments. These risks can increase volatility and decrease performance.
