What is risk?
Risk is usually defined as the volatility an investment is exposed to. Volatility is a measure of the range of returns on an investment over a given period, compared to the mean. The higher the volatility, the riskier the investment.
No one can foresee the future, meaning the risk investments will be exposed to in months or years to come is inherently uncertain. However, the investment management industry can assess the prior performance of a security (meaning a financial asset like a stock or a bond) to form an opinion on how much risk it is likely to be exposed to in future.
Inflation and Returns
Inflation reduces the purchasing power of money. For example, a pint of milk today costs almost double what it did in 1990.
When calculating your return on an investment, inflation needs to be considered. A nominal return is your superficial return on an investment, whereas real returns are adjusted for inflation.
How are returns on bonds calculated?
Credit rating agencies rate bonds by the amount of risk they’re exposed to. If a bond is exposed to more risk – for example, if the business that has issued it is in danger of going bankrupt, meaning the bondholder may not get their money back – it will receive a lower credit rating.
Credit ratings span AAA to D. Any bond below a CCC credit rating is consider a junk, or ‘high yield’ bond. As their name suggests, high yield bonds pay high rates of interest to bondholders, but they are riskier than bonds with better credit ratings.
In contrast, bonds with strong credit ratings (so-called ‘investment-grade’ bonds) are less risky but pay lower yields to investors. A classic example of a very low-risk investment-grade bond is a US Treasury bond. The investor will only not get their money back if the US government is unable to pay its debts, the risk of which is near zero.
Watch: Risk and return summary
There is no ‘right’ approach to portfolio construction. A range of approaches can be appropriate, based on your investment goals, time horizon, risk tolerance and other factors.
Deciding what exposure to different asset classes would be suited to your goals is a real skill. Investors often favour ‘diversified’ portfolios, which are split between different asset classes and types of financial products, with the goal of reducing risk.