Risk-return spectrum
Encyclopedia
The risk-return spectrum is the relationship between the amount of return gained on an investment
and the amount of risk
undertaken in that investment. The more return sought, the more risk that must be undertaken.
; long-term debt; property; high-yield debt; equity. There is considerable overlap of the ranges for each investment class.
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
.
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
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
of that country's central bank
than the market supply conditions for credit
.
. 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 will be.
s. The further away from perfect is the credit rating, the more along the risk-return spectrum is that particular return.
In this arena, the debts are called investment grade by the rating agencies. The lower the credit rating, the higher the yield and thus the expected return.
that the investor rent
s 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).
(also known derisively as junk bonds). These may come from mid and low rated corporations, and less politically stable governments.
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 are generally riskier than large-cap; 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.
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, decreasing the overall risk of the portfolio due to negative correlation with other investments.
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
.
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.
, is a crucial feature of Modern Portfolio Theory
. The line is then called the capital market line.
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 highest-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.
Investment
Investment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...
and the amount of risk
Risk
Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...
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 debtMoney market
The money market is a component of the financial markets for assets involved in short-term borrowing and lending with original maturities of one year or shorter time frames. Trading in the money markets involves Treasury bills, commercial paper, bankers' acceptances, certificates of deposit,...
; long-term debt; property; high-yield debt; equity. There is considerable overlap of the ranges for each investment class.
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
Economic equilibrium
In economics, economic equilibrium is a state of the world where economic forces are balanced and in the absence of external influences the values of economic variables will not change. It is the point at which quantity demanded and quantity supplied are equal...
- 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
Sharpe ratio
The Sharpe ratio or Sharpe index or Sharpe measure or reward-to-variability ratio is a measure of the excess return per unit of deviation in an investment asset or a trading strategy, typically referred to as risk , named after William Forsyth Sharpe...
.
Short-term loans to good government bodies
a lowest end is short-dated loans to governmentGovernment
Government refers to the legislators, administrators, and arbitrators in the administrative bureaucracy who control a state at a given time, and to the system of government by which they are organized...
and government-guaranteed entities (usually semi-independent government departments). The lowest of all is the risk-free rate of return
Risk-free interest rate
Risk-free interest rate is the theoretical rate of return of an investment with no risk of financial loss. The risk-free rate represents the interest that an investor would expect from an absolutely risk-free investment over a given period of time....
. 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
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
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
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...
of that country's central bank
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...
than the market supply conditions for credit
Credit (finance)
Credit is the trust which allows one party to provide resources to another party where that second party does not reimburse the first party immediately , but instead arranges either to repay or return those resources at a later date. The resources provided may be financial Credit is the trust...
.
Mid- and long-term loans to good government bodies
The next types of investment is longer-term loans to government, such as 3-year bondsBond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
. 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 will be.
Short term loans to blue-chip corporations
Following the lowest risk investments are short-dated bills of exchange from major blue-chip corporations with the highest credit ratingCredit rating
A credit rating evaluates the credit worthiness of an issuer of specific types of debt, specifically, debt issued by a business enterprise such as a corporation or a government. It is an evaluation made by a credit rating agency of the debt issuers likelihood of default. Credit ratings are...
s. The further away from perfect is the credit rating, the more along the risk-return spectrum is that particular return.
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-but-not perfectly-rated corporations.In this arena, the debts are called investment grade by the rating agencies. The lower the credit rating, the higher the yield and thus the expected return.
Rental property
A commercial propertyCommercial property
The term commercial property refers to buildings or land intended to generate a profit, either from capital gain or rental income.-Definition:...
that the investor rent
Renting
Renting is an agreement where a payment is made for the temporary use of a good, service or property owned by another. A gross lease is when the tenant pays a flat rental amount and the landlord pays for all property charges regularly incurred by the ownership from landowners...
s 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 debtHigh-yield debt
In finance, a high-yield bond is a bond that is rated below investment grade...
(also known derisively as junk bonds). These may come from mid and low rated corporations, and less politically stable governments.
Equity
EquityOwnership equity
In accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If liability exceeds assets, negative equity exists...
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 are generally riskier than large-cap; 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 leverageLeverage (finance)
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
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, decreasing the overall risk of the portfolio due to negative correlation with other investments.
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
Risk premium
A risk premium is the minimum amount of money by which the expected return on a risky asset must exceed the known return on a risk-free asset, in order to induce an individual to hold the risky asset rather than the risk-free asset...
.
Leverage extends the spectrum
The use of leverageLeverage (finance)
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
can extend the progression out even further. Examples of this include borrowing funds to invest in equities, or use of derivatives
Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
.
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 propertySeparation property (Finance)
A separation property is a crucial element of modern portfolio theory that gives a portfolio manager the ability to separate the process of satisfying investing clients' assets into two separate parts....
, is a crucial feature of Modern Portfolio Theory
Modern portfolio theory
Modern portfolio theory is a theory of investment which attempts to maximize portfolio expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets...
. The line is then called the capital market line.
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 highest-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
Opportunity cost
Opportunity cost is the cost of any activity measured in terms of the value of the best alternative that is not chosen . It is the sacrifice related to the second best choice available to someone, or group, who has picked among several mutually exclusive choices. The opportunity cost is also the...
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 theoryModern portfolio theoryModern portfolio theory is a theory of investment which attempts to maximize portfolio expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets...
- RiskRiskRisk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...
- Financial capitalFinancial capitalFinancial capital can refer to money used by entrepreneurs and businesses to buy what they need to make their products or provide their services or to that sector of the economy based on its operation, i.e. retail, corporate, investment banking, etc....
- InvestmentInvestmentInvestment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...
- CreditCredit (finance)Credit is the trust which allows one party to provide resources to another party where that second party does not reimburse the first party immediately , but instead arranges either to repay or return those resources at a later date. The resources provided may be financial Credit is the trust...
- InterestInterestInterest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....
- Ownership equityOwnership equityIn accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If liability exceeds assets, negative equity exists...
- ProfitProfit (economics)In economics, the term profit has two related but distinct meanings. Normal profit represents the total opportunity costs of a venture to an entrepreneur or investor, whilst economic profit In economics, the term profit has two related but distinct meanings. Normal profit represents the total...
- Leverage (finance)Leverage (finance)In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...