written by: Jason C. Chavis•edited by: Rebecca Scudder•updated: 7/31/2011
The risk-return spectrum is a way of analyzing the potential losses in correlation with the possible gains of an investment. Understanding the basics of risk reward ratio enables an investor to make a more comprehensive decision in regards to where he or she would like be financially vested.
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Getting the Best Return
The value of a return from an investment in relations to the amount of risk undertaken by the investment is known as the risk-reward spectrum. This can also be referred to as risk-return. Essentially, the larger amount of reward an investor seeks, the more risk that investor must undertake.
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The overall risk-reward spectrum is defined by a general progression starting with low-risk, low-reward investments leading to high-risk, high-reward investments. Plotting the progression illustrates a vertical axis that represents the possible reward, while a horizontal axis represents risk. The beginning of the spectrum starts with nearly risk-free investments and rises as the risk increases.
The reason progression exists within the risk reward ratio is due to the fact that the riskier the investment, the more important the reward becomes. Risk creates a situation in which a number of expenses are incurred. Riskier investments require more information and monitoring than less risky investments. In addition, the potential loss from an investment generally outweighs the ramifications of a gain. Thus, risky investments require more compensation.
High returns with low risk attract a large number of investors, which ultimately drives down the rate of return. This ultimately results in an investment that has low returns with low risk. The reverse is also true for investments with low returns and high risk. Ultimately, the investment would again level out. This is the reason the risk-reward spectrum works in a progression.
Right: Risk-Reward Spectrum Graph. (Provided by Flamurai at Wikimedia Commons; GNU Free Documentation License; http://en.wikipedia.org/wiki/File:Capital_Market_Line.png)
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Although many of these investment types overlap, the following examples illustrate the general idea of the progression.
The lowest end of the spectrum is dominated by short-term loans to government bodies. This is because the time frame of the investment is short and inflation should have the least amount of financial impact. An example of this is a 30-day T-Bill from the United States.
Longer term investments into government bodies, such as Treasury bonds, generally lie on the next level of the progression. These are longer-term investments, however, are stable when issued by a reliable government.
Investments into corporations are the next step on the risk-return spectrum, these include short-term and long-term loans. This is influenced by the credit rating of the company. The lower the credit rating, the higher the risk on the investment.
Commercial rental property and high-yield debt continue up the chain of progression. These are widely considered speculative investments that can include a high volume of risk, but also provide a greater return.
Investing in the equity market, such as small-cap stocks, provide some of the largest risks in the economy. This is also true for the futures market.
Many investors who understand the risk-reward spectrum use this progression to hedge against losses, while still maintaining the possibility for greater returns.