risk x return

Different financial products deliver different returns because they carry different risks. Understanding the relationship between risk and return is key to making investment decisions aligned with your goals and your profile.

Why do returns vary?

A central principle of the financial market is simple: higher returns require higher risk. Products considered safer pay less; riskier products offer higher expected returns to compensate for uncertainty.

• Term deposits and savings accounts: generally offer the lowest returns because they are the safest.
• Bonds: usually provide intermediate returns, as they carry less risk than stocks but more than guaranteed deposits.
• Stocks: offer the highest expected returns, but also the greatest volatility and uncertainty about actual returns.

Expected return vs. actual return

The expected return is an average estimate of what an investment should yield. The actual return is what actually occurs, which may be higher, lower, or equal to the expected return.

The difference between actual and expected returns is what we call risk or volatility. The greater this variation, the higher the risk.

How to measure risk

A common statistical measure to capture this uncertainty is the standard deviation. The higher an asset’s return standard deviation, the greater the expected fluctuations and the higher the risk.

To compare investments with the same expected return, it is useful to look at the relationship between return and volatility. This relationship is expressed by the return-to-volatility ratio, commonly known in its more complete form as the Sharpe ratio. In practical terms, the goal is to maximize this ratio: achieve the highest possible return for a given level of risk or minimize risk for a given return.

Know your risk appetite

Deciding how much risk to take is not only a numerical question. You need to evaluate three interconnected dimensions: need, capacity, and willingness to take risks.

• Need: What are your financial goals and timelines? Someone aiming to retire early may need higher returns and, often, more risk to reach this goal.
• Capacity: How much risk can you financially bear? Having dependents, debt, or a small emergency fund reduces your capacity to handle volatility.
• Willingness: How comfortable are you with temporary losses? If anxiety causes you to sell when the market drops, your profile indicates low willingness to take risk.

A useful analogy: investing is like choosing a ride at an amusement park. If you pick a roller coaster that’s too intense for your taste, you might want to get off halfway. In investing, getting off the “ride”—selling after a drop out of fear—can lock in losses and hinder your goals.

Practical rules to align risk and return

• Evaluate your time horizon: longer horizons allow you to accept more volatility in pursuit of higher returns.
• Set clear goals: specific targets guide asset selection and the appropriate level of risk.
• Match products to your profile: those seeking lower risk may prioritize quality bonds, while those seeking growth can increase their stock allocation.
• Maintain an emergency fund: reduces the likelihood of selling investments during market drops.
• Seek risk/return efficiency: prefer investments with better ratios between expected return and volatility (higher Sharpe).
• Stay invested: the ability to endure market fluctuations and remain invested is often crucial to achieving expected long-term returns.

Next step: portfolio diversification

Diversification is the practical tool that helps reduce risk without necessarily sacrificing return. Building a balanced portfolio across assets with different risks and correlations smooths volatility and increases the likelihood of achieving your financial goals.

Understanding risk and return, knowing your profile, and choosing assets consistent with that profile are the foundations of a successful investment strategy. With these fundamentals, it becomes easier to make rational decisions and maintain discipline even during uncertain periods.