|High returns are the reward for
taking high risks. This trade-off is fundamental to all personal
Is 6% a good investment return?
The answer is: it depends. In today's (2008) savings environment
6% is a fantastic return on a cash deposit, an adequate return for
a high-quality short-term corporate bond and a poor return for an
investment in shares.
Why is this?
Suppose government bonds (called "gilt-edged stock", or just "gilts")
are offering a return of 5%. Since the government guarantees these
bonds they are considered risk-free. We say that "the current risk-free
return is 5%".
Compare this with a corporate
For example, one issued by Widgets plc. It has certain characteristics
- an interest yield, a maturity date, a risk of default if Widgets
goes bust, and so on. As an investor, would you buy these bonds
at a price that gives you an expected return of 5%?
Obviously not - because this is no more than
the risk-free return. Why should you take
more risk with no reward?
So what is the right price
for these bonds?
We do not know. But what we do have is a market price. The
many potential buyers and sellers of these bonds, through the wonderful
mechanism of the market, find a price that balances the desires
of buyers and sellers.
Suppose the market price settles at a level
that gives an expected return of 7%. This is 2% above the risk-free
return of 5%. This 2% is what the market has decided is the reward
or "premium" that investors need for taking on the additional
risk of a Widgets bond. It is called the "Widgets bond risk premium".
Is this a good return
for a Widgets bond?
Meaning, is 2% an adequate risk premium for a Widgets bond?
Well, that's a judgement call for each individual.
It may be not enough for you, in which case you are a seller. It
may be fine for me, in which case I am a buyer. So there is no "right"
price. But there is a market price - you'll find it in the newspaper
What about Widgets plc
Would 7% be an adequate return?
Well, no. Any problem with the company and
the shareholders get hit before the bondholders. Plus the income
from a bond is fixed whereas the dividend income from shares is
not. So shares are riskier than bonds. So any investor will want
a premium over the bonds as an incentive to buy the shares.
How much premium?
You are probably ahead of us now. All the previous
paragraphs on the Widgets bonds apply, and the market will settle
on a risk premium that balances buyers and sellers.
Suppose in this case the price of Widgets shares
gives an expected return of 10%. We say that the shares are priced
at a premium of 3% to the bonds. Or, we say that the shares are
priced at a premium of 5% to the risk-free rate (of 5%). We
call this an "equity risk premium" of 5%.
How about shares in Fantasy
Fantasy plc is in the business of selling
dreams, so the market will find its shares much riskier than boring
old Widgets. The market will demand a bigger risk premium than the
5% for Widgets. Maybe 7%, for example, to give a total expected
return of 12% on Fantasy shares
And so on.
The whole spectrum of investment opportunities is connected by risk
premia. The market mechanism ensures that the expected return on
Investment X cannot be more than the expected return on Investment
Y unless X is perceived to be riskier than Y. Otherwise investors
would buy X and sell Y until a reasonable price differential is
....and the lesson for
To get high returns you need to take high risks. High returns are
the reward for taking those risks.
Or, if you are not prepared to take risks you cannot
obtain high returns.
Investment planning is not about "looking for
the highest return". It is about determining what level of return
you feel comfortable looking for. It is quite impossible to undertake
any investment (other than at random) without facing up to this.
But to accept low returns because you feel "safer" is
as negligent, over the long term, as wild punting in Canadian mining
shares. Look at Compounding.