The risk–return spectrum (also called the risk–return tradeoff or risk–reward) is the relationship between the amount of return gained on an
investment and the amount of
risk
In simple terms, risk is the possibility of something bad happening. Risk involves uncertainty about the effects/implications of an activity with respect to something that humans value (such as health, well-being, wealth, property or the environm ...
undertaken in that investment. The more return sought, the more risk that must be undertaken.
The progression
There are various classes of possible investments, each with their own positions on the overall risk-return spectrum. The general progression is:
short-term debt; long-term debt; property; high-yield debt; equity. There is considerable overlap of the ranges for each investment class.
![Sharpe ratio graph](https://upload.wikimedia.org/wikipedia/commons/d/d7/Sharpe_ratio_graph.jpg)
All this can be visualised by plotting expected return on the vertical axis against risk (represented by standard deviation upon that expected return) on the horizontal axis. This line starts at the risk-free rate and rises as risk rises. The line will tend to be straight, and will be straight at
equilibrium - see discussion below on
domination.
For any particular investment type, the line drawn from the risk-free rate on the vertical axis to the risk-return point for that investment has a slope called the
Sharpe ratio
In finance, the Sharpe ratio (also known as the Sharpe index, the Sharpe measure, and the reward-to-variability ratio) measures the performance of an investment such as a security or portfolio compared to a risk-free asset, after adjusting for its ...
.
Short-term loans to good government bodies
On the lowest end is short-dated loans to government and government-guaranteed entities (usually semi-independent government departments). The lowest of all is the
risk-free rate of return. The risk-free rate has zero risk (most modern major governments will inflate and monetise their debts rather than default upon them), but the return is positive because there is still both the
time-preference and
inflation
In economics, inflation is an increase in the general price level of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reduct ...
premium components of minimum expected rates of return that must be met or exceeded if the funding is to be forthcoming from providers. The risk-free rate is commonly approximated by the return paid upon 30-day or their equivalent, but in reality that rate has more to do with the
monetary policy
Monetary policy is the policy adopted by the monetary authority of a nation to control either the interest rate payable for very short-term borrowing (borrowing by banks from each other to meet their short-term needs) or the money supply, often a ...
of that country's
central bank
A central bank, reserve bank, or monetary authority is an institution that manages the currency and monetary policy of a country or monetary union,
and oversees their commercial banking system. In contrast to a commercial bank, a central b ...
than the market supply conditions for
credit
Credit (from Latin verb ''credit'', meaning "one believes") is the trust which allows one party to provide money or resources to another party wherein the second party does not reimburse the first party immediately (thereby generating a debt) ...
.
Mid- and long-term loans to good government bodies
The next types of investment is longer-term loans to government, such as 3-year
bonds. The range width is larger, and follows the influence of increasing risk premium required as the maturity of that debt grows longer. Nevertheless, because it is debt of good government the highest end of the range is still comparatively low compared to the ranges of other investment types discussed below.
Also, if the government in question is not at the highest jurisdiction (i.e., is a state or municipal government), or the smaller that government is, the more along the risk-return spectrum that government's
securities
A security is a tradable financial asset. The term commonly refers to any form of financial instrument, but its legal definition varies by jurisdiction. In some countries and languages people commonly use the term "security" to refer to any for ...
will be.
Short-term loans to blue-chip corporations
Following the lowest-risk investments are short-dated
bills of exchange
A negotiable instrument is a document guaranteeing the payment of a specific amount of money, either on demand, or at a set time, whose payer is usually named on the document. More specifically, it is a document contemplated by or consisting of a ...
from major
blue-chip corporations with the highest
credit rating
A credit rating is an evaluation of the credit risk of a prospective debtor (an individual, a business, company or a government), predicting their ability to pay back the debt, and an implicit forecast of the likelihood of the debtor defaulting.
...
s. The further away from perfect the credit rating, the higher up the risk-return spectrum that particular investment will be.
Mid- and long-term loans to blue-chip corporations
Overlapping the range for short-term debt is the longer term debt from those same well-rated corporations. These are higher up the range because the maturity has increased. The overlap occurs of the mid-term debt of the best rated corporations with the short-term debt of the nearly perfectly, but not perfectly rated corporations.
In this arena, the debts are called
investment grade
In investment, the bond credit rating represents the credit worthiness of corporate or government bonds. It is not the same as an individual's credit score. The ratings are published by credit rating agencies and used by investment professiona ...
by the rating agencies. The lower the credit rating, the higher the yield and thus the expected return.
Rental property
A
commercial property
Commercial property, also called commercial real estate, investment property or income property, is real estate (buildings or land) intended to generate a profit, either from capital gains or rental income. Commercial property includes office b ...
that the investor rents out is comparable in risk or return to a low-investment grade. Industrial property has higher risk and returns, followed by residential (with the possible exception of the investor's own home).
High-yield debt
After the returns upon all classes of investment-grade debt come the returns on
speculative-grade high-yield debt
In finance, a high-yield bond (non-investment-grade bond, speculative-grade bond, or junk bond) is a Bond (finance), bond that is rated below investment grade by credit rating agencies. These bonds have a higher risk of default (finance), defau ...
(also known derisively as
junk bonds
In finance, a high-yield bond (non-investment-grade bond, speculative-grade bond, or junk bond) is a bond that is rated below investment grade by credit rating agencies. These bonds have a higher risk of default or other adverse credit events ...
). These may come from mid and low rated corporations, and less politically stable governments.
Equity
Equity returns are the profits earned by businesses after interest and tax. Even the equity returns on the highest rated corporations are notably risky.
Small-cap stocks
Market capitalization, sometimes referred to as market cap, is the total value of a publicly traded company's shares outstanding, outstanding common shares owned by stockholders.
Market capitalization is equal to the share price, market price p ...
are generally riskier than
large-cap
Market capitalization, sometimes referred to as market cap, is the total value of a publicly traded company's outstanding common shares owned by stockholders.
Market capitalization is equal to the market price per common share multiplied by ...
; companies that primarily service governments, or provide basic consumer goods such as food or utilities, tend to be less volatile than those in other industries. Note that since stocks tend to rise when corporate bonds fall and vice versa, a portfolio containing a small percentage of stocks can be less risky than one containing only debts.
Options and futures
Option and futures contracts often provide
leverage
Leverage or leveraged may refer to:
*Leverage (mechanics), mechanical advantage achieved by using a lever
* ''Leverage'' (album), a 2012 album by Lyriel
*Leverage (dance), a type of dance connection
*Leverage (finance), using given resources to ...
on underlying stocks, bonds or commodities; this increases the returns but also the risks. Note that in some cases, derivatives can be used to
hedge
A hedge or hedgerow is a line of closely spaced shrubs and sometimes trees, planted and trained to form a barrier or to mark the boundary of an area, such as between neighbouring properties. Hedges that are used to separate a road from adjoin ...
, decreasing the overall risk of the portfolio due to negative correlation with other investments.
Cryptocurrencies
Having no earnings and paying no coupons, rents or dividends, but instead representing stake in an entirely new monetary system of questionable potential, cryptocurrencies are undoubtedly the highest risk investment known to man. These range from Bitcoin and Ethereum to projects of murky origin and utility which in the riskiest cases are scarcely differentiable from an unregistered security or Ponzi scheme. The maturer, larger-cap projects have had similar volatility with small cap stocks in recent years.
Why the progression?
The existence of risk causes the need to incur a number of expenses. For example, the more risky the investment the more time and effort is usually required to obtain information about it and monitor its progress. For another, the importance of a loss of X amount of value is greater than the importance of a gain of X amount of value, so a riskier investment will attract a higher risk premium even if the forecast return is the same as upon a less risky investment. Risk is therefore something that must be compensated for, and the more risk the more compensation required.
If an investment had a high return with low risk, eventually everyone would want to invest there. That action would drive down the actual rate of return achieved, until it reached the rate of return the market deems commensurate with the level of risk. Similarly, if an investment had a low return with high risk, all the present investors would want to leave that investment, which would then increase the actual return until again it reached the rate of return the market deems commensurate with the level of risk. That part of total returns which sets this appropriate level is called the
risk premium
A risk premium is a measure of excess return that is required by an individual to compensate being subjected to an increased level of risk. It is used widely in finance and economics, the general definition being the expected risky return less t ...
.
Leverage extends the spectrum
The use of
leverage
Leverage or leveraged may refer to:
*Leverage (mechanics), mechanical advantage achieved by using a lever
* ''Leverage'' (album), a 2012 album by Lyriel
*Leverage (dance), a type of dance connection
*Leverage (finance), using given resources to ...
can extend the progression out even further. Examples of this include
borrowing funds to invest in equities, or use of
derivatives.
If leverage is used then there are two lines instead of one. This is because although one can invest at the risk-free rate, one can only borrow at an interest rate according to one's own credit-rating. This is visualised by the new line starting at the point of the riskiest unleveraged investment (equities) and rising at a lower slope than the original line. If this new line were traced back to the vertical axis of zero risk, it will cross it at the borrowing rate.
Domination
All investment types compete against each other, even though they are on different positions on the risk-return spectrum. Any of the mid-range investments can have their performances simulated by a portfolio consisting of a risk-free component and the highest-risk component. This principle, called the
separation property, is a crucial feature of
modern portfolio theory
Modern portfolio theory (MPT), or mean-variance analysis, is a mathematical framework for assembling a portfolio of assets such that the expected return is maximized for a given level of risk. It is a formalization and extension of diversificati ...
. The line is then called the
capital market line
Capital market line (CML) is the tangent line drawn from the point of the risk-free asset to the feasible region for risky assets. The tangency point M represents the market portfolio, so named since all rational investors (minimum variance criteri ...
.
If at any time there is an investment that has a higher Sharpe ratio than another then that return is said to dominate.
When there are two or more investments above the spectrum line, then the one with the highest Sharpe ratio is the most dominant one, even if the risk and return on that particular investment is lower than another. If every mid-range return falls below the spectrum line, this means that the lowest-risk investment has the highest Sharpe Ratio and so dominates over all others.
If at any time there is an investment that dominates then funds will tend to be withdrawn from all others and be redirected to that dominating investment. This action will lower the return on that investment and raise it on others. The withdrawal and redirection of capital ceases when all returns are at the levels appropriate for the degrees of risk and commensurate with the
opportunity cost arising from competition with the other investment types on the spectrum, which means they all tend to end up having the same Sharpe Ratio.
See also
*
Modern portfolio theory
Modern portfolio theory (MPT), or mean-variance analysis, is a mathematical framework for assembling a portfolio of assets such that the expected return is maximized for a given level of risk. It is a formalization and extension of diversificati ...
*
Risk
In simple terms, risk is the possibility of something bad happening. Risk involves uncertainty about the effects/implications of an activity with respect to something that humans value (such as health, well-being, wealth, property or the environm ...
*
Financial capital
Financial capital (also simply known as capital or equity in finance, accounting and economics) is any economic resource measured in terms of money used by entrepreneurs and businesses to buy what they need to make their products or to provi ...
*
Investment
*
Credit
Credit (from Latin verb ''credit'', meaning "one believes") is the trust which allows one party to provide money or resources to another party wherein the second party does not reimburse the first party immediately (thereby generating a debt) ...
*
Interest
In finance and economics, interest is payment from a borrower or deposit-taking financial institution to a lender or depositor of an amount above repayment of the principal sum (that is, the amount borrowed), at a particular rate. It is distin ...
*
Ownership equity
In finance, equity is ownership of assets that may have debts or other liabilities attached to them. Equity is measured for accounting purposes by subtracting liabilities from the value of the assets. For example, if someone owns a car worth $2 ...
*
Profit
*
Leverage (finance)
References
# Campbell, John Y., and Luis Viceira. The term structure of the risk-return tradeoff. No. w11119. National Bureau of Economic Research, 2005.
# Lundblad, Christian. "The risk return tradeoff in the long run: 1836–2003." Journal of Financial Economics 85.1 (2007): 123-150.
# Lettau, Martin, and Sydney Ludvigson. "Measuring and modeling variation in the risk-return tradeoff." Handbook of Financial Econometrics 1 (2003): 617-690.
# Ghysels, Eric, Pedro Santa-Clara, and Rossen Valkanov. "There is a risk-return trade-off after all." Journal of Financial Economics 76.3 (2005): 509-548.
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Investment
Portfolio theories