The return-risk binomial shows the direct relationship that exists between the return and the risk of savings and investment products.
Actually, this binomial tells us that profitability and risk go together. If one changes, the other also. The question being discussed is whether this relationship is always direct, that is, if one increases, the other does as well.
For example, if we want to buy a share or a public debt bond, it is normal for the former to offer us higher returns via dividends, since it is safer. Thus, the bond is guaranteed by the State, while the results of the companies are usually variable from one period to another. But let’s see that it doesn’t always work that way.
Return-risk binomial. the classic model
The classic model posits a direct relationship between risk and return. Thus, if we want greater profitability, we must assume greater risk. In this way, the less conservative investors are the ones who expect to obtain higher profits.
In addition, the price of the asset is also related to both variables. The lower it is, the higher return we expect to obtain (we will add that of the possible sale) and the lower risk of loss for the investor (less cost). Therefore, in this case the relationship with the price is inverse.
This binomial is an explanation of what happens in the world of finance, or at least it was. Because here the concept of “intrinsic value” and a very emotional man called Mr. Market, who we explain below, take on special relevance.
Return-risk binomial. Mr Market
Benjamin Graham wrote the book “The Intelligent Investor” and did not believe the same as the classical theory about the behavior of both variables. He gave the example of a man, whom he called Mr. Market (Mr. Market) and that he considered that he was irrational and very emotional. One day he woke up optimistic and bought and the next he was pessimistic and sold, but without logic.
In this way, what we could call a binomial return-inverted risk can be given. Thus, we could find investment opportunities when the price of a low-risk stock falls below its intrinsic or fundamental value, based on the analysis of its annual accounts. That is, we can find investment exceptions.
Types of investors and risks
We can establish three types of inverters based on this binomial:
- The conservative investor: He seeks security and is willing to sacrifice profitability to achieve it. Therefore, he would prefer public debt or very solvent companies and would not venture into the business opportunities offered by Mr. Market.
- Moderate investor: He likes the return a bit and is willing to take a little more risk. They tend to opt for investments that have a moderate risk-return binomial and can even make some small value in cryptocurrencies or currencies. Sometimes he is interested in what Mr. Market has to offer.
- risky investor: This is the type of person who faces risk and also likes it, because he knows that it brings a higher return. Of course, the virtual currency market or Forex attracts him and sometimes he goes too far. He is usually aware of Mr. Market’s decisions
In addition, the risks are varied and whatever investor you are, you must take them into account.
- First, the price or market risk, which will depend on supply and demand to go down or up, so that it can increase or decrease.
- The liquidity risk, because sometimes we cannot recover the investment without penalizing part of it and that can cause us a financial disorder.
- political risk. Although in developed countries it is usually more moderate, monetary or fiscal policy measures affect the price of shares and, therefore, the risk of their price rising or falling.
- Inflation risk. The continued rise in prices makes money lose value and must be subtracted from the expected return. Thus, it is another type of risk to take into account.
- Exchange rate risk. Depending on the currency we use, the exchange rate will affect the price and, therefore, can increase or reduce the risk in our investment.
Example of a return-risk binomial
Finally, let’s see a fictitious example of this relationship between risk and return. Let’s imagine that we are investors and we have a stock for which we have prepared a table with different variables for five years.
The table shows the values of that return and risk (fictitious), the market price, an intrinsic value as an example and the expected relationship between both variables. Let’s look at the different situations that can occur.
The first year we have a market price lower than the intrinsic value, an opportunity. This will provide us with added potential profitability, since we will be able to sell more expensively. Also, since the price is low, the risk of it falling further is lower. It seems that Mr. Market, in this case, has woken up pessimistic and has started to sell, lowering the price.
The second year the price is the same, therefore, the return and the risk do not vary. However, the third, the price rises above the intrinsic value, therefore, the direct relationship of the binomial seems to work and there is no investment opportunity. In this case, Mr. Market has gotten up optimistic and has dedicated himself to buying.
The rest of the periods work in the same way. In this way, the return-risk binomial seems to work most of the time. That yes, Mr. Market teaches us that not always and that it is then when we can have an investment opportunity that should not be disregarded.