Risk and Return When Investing: What Suits Your Risk Profile?

People investing money generally pursue a clear objective: Wealth should grow over the long term. However, every investment decision incorporates uncertainty. Prices can rise or fall, interest rates change, and economic developments can change expectations.

That’s why risk and return are inextricably linked when investing. As a rule, those looking for higher returns also have to also accept sharper value fluctuations and potential losses. The key doesn’t involve avoiding risk altogether. It’s more important to understand one’s own risk profile, and to select an investment strategy that suits your personal circumstances. 

Return indicates what amount an investment generates over a defined period of time. It can turn out to be positive or negative. A positive return means that an investment has increased in value, or has distributed earnings. A negative return means that a loss has occurred.

With many investment types, the return consists of several components:

• Price gains: The value of a stock, bond, or fund unit increases.
• Dividends: Companies share their profits with their shareholders.
• Interest: Investors receive interest payments on bonds or savings accounts.
• Distributions: Funds or ETFs can distribute investment income to investors.

A simple example: An investor buys a stock for 100 Swiss francs. After a year, the price for that same stock is 106 Swiss francs. Additionally, the company paid out two Swiss francs in dividends. In this example, the overall return before fees and taxes amounts to eight Swiss francs, or 8%.

It’s important to note: Past returns do not guarantee future performance. Even an investment that has brought positive returns over many years can intermittently show a loss.

The risk-return relationship refers to the fundamental connection between potential return and uncertainty. In simple terms: In most cases, the higher the expected return of an investment, the higher the risk is.

An investment with minor fluctuations and a high degree of certainty typically offers a limited potential for returns. Stocks or equity funds can offer greater potential for returns over the long term. At the same time their price can fluctuate significantly in the short term. Anyone who invests must therefore be prepared for an investment to perform differently than expected.

But that doesn’t go far enough. In investing, risk refers to the possibility that an investment fails to perform as expected, or that some of the invested capital is lost.

The Most Important Risks When Investing Include:

• Market risk: The entire market declines due to economic, political, or monetary policy developments.
• Corporate risk: A company fails to perform as expected, loses market share, or finds itself in financial difficulties.
• Interest rate risk: Changes in interest rates can have a particular impact on the price of bonds.
• Inflation risk: The purchasing power of the assets sinks when inflation rate is higher than the rate of return on an investment.
• Liquidity risk: An investment can’t be sold off whenever desired, or only at a reduced price.
• Time point risk: The capital is required precisely when the markets or the investment in question has lost value.
• Concentration risk: A portfolio is too dependent on a single stock, sector, region, or asset class.

Not every risk can be avoided. Investors can, however, influence the degree to which they are exposed to individual risks. Broad diversification – i.e., the distributing capital across different investments, sectors, or regions can, for example, help reduce the risks associated with individual positions. But it doesn’t offer complete protection against loss, especially not in the case of a broad market downturn.

An important term when discussing investment risk is volatility. It refers to the degree to which the price of an investment fluctuates over a defined period of time. High volatility means that the price can move up or down quickly and significantly.

But volatility is not the same as a permanent loss.

If the price of a stock dips briefly due to market uncertainty and recovers again, the investment is said to be volatile. The invested capital isn’t necessarily permanently lost. It’s a different situation if a company permanently loses value or becomes insolvent. In that situation, an actual capital loss can occur.

This distinction is especially relevant when markets are unsettled. Short-term price movements are a part of investing. Whether or not this is a problem for investors depends heavily on whether or not the money is needed at short notice, and if the selected investment strategy remains suitable given their personal circumstances.

Before determining an investment strategy, investors should know their personal risk profile. This doesn’t just involve determining how much return is desired, but also how much emotional and financial risk the investor is able to bear. Two key components of a risk profile are risk tolerance and risk capacity.

The personal risk profile can be simplified into two components:

• Risk tolerance: How much risk do I wish to take on?
•  Risk capacity: How much risk can I take on?

In determining an investment strategy, it’s typically the more cautious of the two factors that is decisive. Anyone unable to tolerate high risks emotionally, or bear them financially, should not take those risks.  

Risk tolerance refers to personal readiness from an emotional perspective to withstand financial fluctuations and potential losses. It is thus a question of psychology.

Some people remain calm when their portfolio temporarily loses value. They understand that markets fluctuate, and are focused on long-term objectives. Others already feel uneasy when small losses occur, and wish to sell the investment as soon as possible.

Both are understandable. It’s crucial that the investment strategy not only makes sense on paper, but that it can be maintained, especially during difficult market phases. 

These questions can help you better assess your own risk tolerance:

• How would I react if my portfolio lost 10% or 20% of its value within a short time?
• Would I remain calm if I took losses, or would I feel compelled to sell off quickly?
• How comfortable am I with price fluctuations and uncertainty?
• Could I accept temporary losses if I remain confident in my long-term strategy?

A high risk tolerance does not automatically mean that someone should take on high risks. It merely shows how well someone can deal with uncertainty. Risk tolerance is thus only a part of one’s personal risk profile.

Risk capacity refers to the objective financial ability to absorb losses or value fluctuations. It depends less on personal attitudes than it does on financial circumstances.

Important factors include:

• Amount and stability of income
• Existing liquidity reserves
• Assets and ongoing financial obligations
• Loans and other debts
• Family and other care obligations
• Time when the money is needed
• Significance of the investment objective

The investment horizon plays a central role in this. Someone who will need money in a few months or years is less able to ride out a significant price drop than someone who invests over decades.

Suppose someone is saving for the down payment on an apartment they plan to buy in two years. In this case, a portfolio weighted heavily in stocks can be risky since a market decline shortly before the purchase could significantly reduce the amount of capital available. Risk capacity in this situation is limited, even if the person would generally be prepared to assume high risks.

The situation may be different when it comes to a long-term retirement planning goal. Someone who invests over many years, has sufficient reserves, and isn’t dependent on the capital in the short term can withstand price fluctuations better in some circumstances.

Risk tolerance and risk capacity are often confused with each other. However, they answer different questions. Ideally, the two factors will match. 

The term investment horizon refers to the period during which the money can remain invested before it is required for a particular goal. It significantly influences how well short-term market movements can be withstood.

The longer the investment horizon, the better the chances of riding out temporary downturns. The shorter the investment horizon, the greater the risk that the investor will have to sell at an inopportune time.

A long-term investment horizon doesn’t guarantee a positive return. However, it can help bring short-term volatility into better perspective. That’s because the significance of individual market phases diminishes if the capital isn’t needed right away.

This doesn’t mean that investors taking a long-term approach should ignore price fluctuations. Rather, it means that the strategy should be aligned with a long-term goal from the beginning. Those looking for long-term growth generally have to accept that the path to that objective isn’t linear. The investment horizon is one of the most important factors in determining how much volatility is reasonable and sustainable within an investment strategy.

A risk profile is not something you decide once and then leave unchanged. Living circumstances, financial means and objectives can change.

Reviewing your investment strategy can make sense if:

• your income or employment situation changes significantly.
• you plan to make a major purchase such as real estate. 
• you’ve started a family, or have new financial obligations.
• you’re nearing retirement.
• you’re received an inheritance, seen a sizeable growth in assets, or have incurred new debts.
• your investment goals have changed.

It’s important to make a distinction between a real change in personal circumstances and a short-term reaction to market fluctuations. A brief decline in prices on its own is not automatically a reason to question the entire strategy. However, if the timing of an important goal changes, or the capital will be needed soon, an adjustment may be appropriate.