Generally, the higher the potential return of an investment, the higher the risk. There is no guarantee that you will actually get a higher return by accepting more risk.
Diversification enables you to reduce the risk of your portfolio without sacrificing potential returns. Once your portfolio has been fully diversified, you have to take on additional risk to earn a higher potential return on your portfolio.
Understanding risk and return
Some investments are riskier than others – there’s a greater chance you could lose some or all of your money. For example, Canada Savings Bonds (CSBs) have very low risk because they are issued by the government of Canada. GICs and bank deposits also carry low risk because they are backed by large financial institutions. With GICs and deposits you also have the additional protection of deposit insurance on amounts up to $100,000 if your financial institution goes bankrupt. With these low-risk investments you are unlikely to lose money. However, they have a lower potential return than riskier investments and they may not keep pace with inflation.
Over the long-term, bonds have a potentially higher return than CSBs and GICs, but they also have more risks. Their prices may drop if the issuer’s creditworthiness declines or interest rates go up. If prices drop, you will incur a loss.
Stocks have a potentially higher return than bonds over the long termTerm The period of time that a contract covers. Also, the period of time that an investment pays a set rate of interest.+ read full definition, but they are also riskier. BondBond A kind of loan you make to the government or a company. They use the money to run their operations. In turn, you get back a set amount of interest once or twice a year. If you hold bonds until the maturity date, you will get all your money back as well. If you sell…+ read full definition investors are creditors. As a bond investor, you’re legally entitled to fixed amounts of interest and principalPrincipal The total amount of money that you invest, or the total amount of money you owe on a debt.+ read full definition and are repaid in priority if the company goes bankrupt. However, if the company is successful, you won’t earn more than the fixed amounts of interest and principal. Shareholders are owners. As a shareholderShareholder A person or organization that owns shares in a corporation. May also be called a investor.+ read full definition, if the company is unsuccessful, you could lose all of your money. But if the company is successful, you could see higher dividends and a rising shareShare A piece of ownership in a company. A share does not give you direct control over the company’s daily operations. But it does let you get a share of profits if the company pays dividends.+ read full definition price.
Some investments, such as those sold on the exempt market are highly speculative and very risky. They should only be purchased by investors who can afford to lose all of the money they have invested.
DiversificationDiversification A way of spreading investment risk by by choosing a mix of investments. The idea is that some investments will do well at times when others are not.+ read full definition and the risk-return relationship
This chart shows the impact of diversification on a portfolioPortfolio All the different investments that an individual or organization holds. May include stocks, bonds and mutual funds.+ read full definition, and what happens to risk when you want to increase potential return.
The equity premium
Treasury bills issued by the Canadian government are so safe that they are considered to be virtually risk-free. The government is unlikely to default on its debtDebt Money that you have borrowed. You must repay the loan, with interest, by a set date.+ read full definition because it has the power to raise revenues through taxes and to print money.
At the other extreme, common shares are very risky because they have no guarantees and shareholders are paid last if the company is in trouble or goes bankrupt.
Investors must be paid a premium, in the form of a higher average return, to compensate them for the higher risk of owning shares. The additional return for holding shares rather than safe government debt is known as the equityEquity Two meanings: 1. The part of investment you have paid for in cash. Example: you may have equity in a home or a business. 2. Investments in the stock market. Example: equity mutual funds.+ read full definition premium. This Interactive investing chart shows that the average annual return on treasury bills since 1935 was 4.5%, compared to a 9.6% return on Canadian stocks. Consequently, the historical equity premium was approximately 5% per annum. However, past returns are not always an indication of future performance.
Risk needs to be considered at all investing stages and for different goals.