Eat Well, Sleep Well

"Eat well, sleep well" is an adage that, referring to the risk-return tradeoff, says that the type of security an investor chooses depends on whether he or she wants to generate high returns or have peace of mind. This tradeoff can be thought of as balancing return needs and risk tolerance.

Investing in securities with high expected returns offers investors the potential to generate large earnings (eat well), but the high risk and volatility associated with these securities might lead to losses, or, at best, a great deal of volatility along the way. By contrast, investing in low-risk assets can minimize the potential for loss and generate smoother returns (sleep well), though the expected returns will be lower.

Investors often must balance their return needs and goals with their individual risk tolerances. This tradeoff can be referred to as “eat well, sleep well.”

Risk-return is the relationship between the potential amount of return gained on an investment and the amount of risk an investor must accept to participate in that investment. The higher the return desired, the more risk the investor must accept.

Each investment has its own position on the overall risk-return spectrum. The general progression short-term debt; long-term debt; property; high-yield debt; equity. There is considerable overlap among the investment classes.

Each investor’s risk tolerance is the single most important factor in constructing an investment portfolio. Also, risk tolerance may change over time, so it is important to revisit the topic periodically.

Some trial and error is usually required to determine the best risk-return ratio for a given investor, and many investors have a specified risk/reward ratio for their investments.

The existence of risk causes the need to incur expenses. For example, the riskier the investment, the more time and effort is usually required to research and monitor it. Also, the importance of a potential loss value is greater than the importance of a gain value, so a riskier investment will attract a higher risk premium even if the forecast return is the same as a less risky investment. Therefore, investors expect to be compensated for taking risks.

If an investment had a high return with low risk, everyone would want to invest in it. That would drive down the actual rate of return, until it reached a level where the return was no longer commensurate with the risk. The part of total returns that sets this appropriate level is called the risk premium.