Q4 ’23 Market Letter: The Risk/Reward Spectrum in Investing

By Ryan Ross on October 16, 2023

Investing is the process of allocating money to an asset or a venture with the expectation of generating a positive return over time. However, investing is not without risk. Risk is the possibility of losing some or all of the original investment, or not earning the expected return. Different types of investments have different levels of risk and potential return, and investors need to balance these two factors according to their goals, preferences, and tolerance.

The risk/reward spectrum is a way of visualizing the relationship between risk and return in investing. It shows that generally, higher-risk investments offer higher potential returns, while lower-risk investments offer lower potential returns. The risk/reward spectrum can help investors choose the appropriate mix of investments for their portfolio, depending on their risk profile and time horizon.

The risk/reward spectrum can be divided into four main categories: cash equivalents, fixed income (bonds), equities (stocks), and alternative investments.

Source: https://usaaef.org/invest-for-the-future/investing/investing-for-growth/the-four-main-asset-classes/; as of October 16, 2023

Cash equivalents are traditionally the lowest-risk and lowest-return investments on the spectrum. They include money market funds, certificates of deposit (CDs), treasury bills, and other short-term instruments that provide liquidity and safety of principal. Cash equivalents typically offer returns that are slightly above inflation, but they do not offer any capital appreciation.

Fixed income (bond) investments are slightly higher-risk and higher-return than cash equivalents. They pay a fixed or variable interest rate to the investor. Fixed income investments normally provide a steady stream of income and some protection against inflation, but they also expose the investor to interest rate risk, credit risk, and reinvestment risk.

Equities (stocks) are higher-risk and higher-return than fixed income investments. They represent ownership in a company or a basket of companies. Equities offer the potential for capital appreciation and dividend income, but they also expose the investor to market risk, company risk, and volatility.

Alternative investments are the highest-risk and highest-return investments on the spectrum. They include hedge funds, private equity, real estate, commodities, derivatives, and other assets that are not traded on public markets or regulated by authorities. Alternative investments offer the possibility of diversification and exceptional returns, but they also involve high fees, low liquidity, limited transparency, and complex strategies.

The risk/reward spectrum is not a fixed or universal concept. It can vary depending on the market conditions or specific characteristics of each investment. For example, some equities may be riskier than some alternative investments, or some fixed income investments may offer lower returns than some cash equivalents. Therefore, investors should not rely solely on the risk/reward spectrum to make their investment decisions, but rather use it as a general guide to understand the trade-offs involved in investing.

Today’s environment is one of those times when the spectrum is turned upside down. Due to the Federal Reserve’s interest rate hiking campaign to beat high inflation, short-term cash equivalent investments are currently offering much higher returns than would normally be expected given the risk/reward trade-off. To wit, using current yield for money market funds and bonds versus earnings yield (earnings per share divided by price) for the S&P 500 (a proxy for stocks), we find that equities look very unattractive considering their significantly higher risk (as measured by a 3-year average standard deviation).

In reviewing the graph below, where we compare the current expected risk/return tradeoff (orange) versus that of January 2022 (blue — before the Fed started hiking rates), the difference is stark. While equities are yielding a bit higher than before, given the drop in the stock market (the price denominator in our earnings yield fraction as referenced above) since January 2022, it is the cash equivalent and fixed income segments that are much more attractively valued today.

This is not to say that we should sell all of our stocks and move into cash and bonds, but shifting to a less risky posture does not mean giving up potential return, as is true in more normal environments. Prudent portfolio management suggests at least trimming at the edges. Staying on top of the spectrum, that’s HMA!