Risk and Return

Related Terms: Bonds; Stocks

It is an axiom of financial transactions that the highest returns go with the highest risks and, conversely, the safest investments have the lowest returns. The only real difference between buying something and investing in something is the level of uncertainty involved. When the certainty of reward is virtually assured, we call it purchasing; when there is risk but it is low, we speak of lending; when risks are higher, we call it investing; when even higher we call it speculation; and the most extreme form of this activity is gambling. Moving up this chain both the returns and the risks increase—moving down the reverse is true. Even a person buying a car can sometimes end up with a lemon—but he or she has warranty claims to exercise. But the person putting a large sum on red or black on the roulette table has a 50-50 chance of losing it all.

The investment world has developed a rich array of instruments to enable those who lack money but have ideas for creating new wealth to obtain money from those who have the funds but either lack the time, skill, or enterprise to go venturing themselves. The fundamental divisions are described by the common phrase of "stocks and bonds." In a very general sense stocks are risky and have high yield and bonds are safe but produce low returns. But this formulation is far too broad for general use. Sorting out the nuances of risk and return requires a closer look. Financial markets are both innovative and competitive. For this reason virtually every conceivable niche available has been populated by financial instruments that attempt to minimize the negatives involved and to hedge the risks—not least hedge funds.

BASIC DIVISIONS

In the first quarter of 2006, more than two-thirds of roughly $38 trillion in investment funds (68.7 percent) were allocated to debt instruments of one sort or another and somewhat under a third (31.3 percent) were held in the form of stock. These were domestic figures for bond debt (of $25.86 trillion in the first quarter of 2006) as reported by the Bond Market Association and figures for the market capitalization of U.S. stocks (at $11.8 trillion) as reported by Charles Schwab, citing Morgan Stanley Capital International. These ratios change over time, of course. In 2000 investment funds were divided almost equally between bond debt and market capitalization, 2000 having experienced a peak of stock capitalization of $17 trillion. The allocation of money between these two major categories is itself a reflection of risk: in periods of expansion (one of which peaked in 2000) money is drawn to stocks; in times of decline, money is invested in bonds. Both bonds and stocks are discussed in more detail elsewhere in this volume.

Stocks

Stocks are typically classified by market capitalization and divided into Large, Medium or Mid, and Small capitalizations ("large-caps," "mid-caps," etc.). Large-caps have $10 to $200 billion in capitalization, mid-caps $2 to $10 billion, small-caps $300 million to $2 billion. The market capitalization is the value per share multiplied by the shares outstanding. Risks are greatest with small-caps but upward potential is greatest as well—so that financial journals routinely report on the exciting promise of small-caps. The great and massive large-caps, however, are unlikely to surprise anyone—except perhaps by spectacular and sudden failure, like Enron Corporation.

Most ordinary people participate in the stock market by buying mutual funds offered by fund managers. Funds come in a great many varieties but have the common feature of combining different kinds of stocks to maximize returns, stock appreciation, safety, and even stockholder aspirations. Some funds favor "green" companies, others avoid tobacco or alcohol or favor companies owned or controlled by religious affiliations. In that they combine many companies into a single instrument, a mutual fund is often less risky than the stock of a single company. Fund managers are rewarded for closely tracking trends in the market and making swift changes to maintain the fund's value.

A particularly interesting and complex type of fund is the hedge fund. Hedge funds are not regulated on the assumption that only highly sophisticated investors will participate in them. Some restrictions apply, including the number of investors and minimum assets that investors must have to participate. Being otherwise unregulated, they are opaque to view and thus on the face of it highly risky—although their intention is to "hedge" against the risk of the stock market. Hedging is to balance one risk by another—thus to invest in oil but to balance it by investing in windmills as well. In actual practice, hedge funds combine many different techniques, including selling stocks short, buying on one market and selling on another in order to realize a temporary differential in prices between the two, buying futures, and leveraging investor funds by borrowing. Sophisticated market knowledge and rapid execution are hall marks of hedge funds. But pure leverage would rarely make money. For this reason hedge funds are somewhat misnamed.

BONDS

It is useful to remember that "bonds"—whatever name they might actually bear—are ultimately loans. Thus in a sense all loans are bonds and all bonds are loans. A certificate of deposit (CD), a private placement, a savings account, a corporate bond, a treasury bill, a bank loan—all can be clustered under the generic "bond" designation because all types of loan instruments are ultimately bought, sold, and traded.

Bond debt is reported under seven major categories by the Bond Market Association. In order of magnitude the categories are mortgage-backed securities (23.6 percent), corporate bonds (19.7), Treasury notes (16.7), money market funds (13.5), federal agency bonds (10.2), municipal bonds (8.6), and asset-backed instruments (public and private placements—7.6 percent of total). Money market funds are commercial loans, bankers' acceptances, and large time deposits. These instruments represent different mixtures of security, time commitment, and return. Mortgage-backed securities are long-term debt on homes and other real estate and thus well-secured. Corporate bonds depend on the bond rating and may be quite secure or risky ("junk bonds"). Treasury notes are considered the most secure debt instruments of all; they are short-term instruments. Municipal bond yields are tax-free and hence desirable for that reason.

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