There is a relationship between risk and reward that is reflected in the interest rates we’re charged on loans and the returns paid on various investments. What is the relationship between risk and reward? And how is the reward you should expect for an investment determined?
We tend to receive a low interest rate on savings because the money is guaranteed, whether it is sitting in a savings account or we’re holding onto cash. Banks offer interest to their account holders paid for by lending the money out to individuals and businesses. The bank charges interest on the loans they offer, and after loan administrative and other overhead costs, they pay their account holders interest. This is a step up from the fees people used to pay banks for protecting their cash, simply for the privilege of protecting the cash from theft.
Savings have benefits beyond the value of the money sitting in your account. If you have a savings account with several months of income, you won’t have to go into debt at a steep interest rate in order to pay living expenses when you’ve lost your job. Saving up for a large purchase like a car or home reduces the interest you’ll pay later.
Investing is defined by the higher risk and, in general, higher rewards. When an investment firm gives businesses money, they typically invest it in new facilities, expanded product lines, upgraded equipment and other projects that increase productivity or profitability. However, there is a risk that the project will fail. The business may expand but find there isn’t enough demand for the new production, and they sell the excess at a loss. Or they built new locations, but they find that their projections were overly optimistic. A business that overextends itself may be hampered by debt payments before going bankrupt. Businesses pay a higher interest rate on money lent to them or a significant share of their profits to investors to make up for that risk.
Bonds pay less than stocks because they are seen as lower risk. The value of the bonds is affected by interest rates, since you lose money if interest rates approach the interest paid on the bond.
Risks You Take in Both Saving and Investing
You risk receiving less in interest than the rate of inflation, something called negative interest rates. Conversely, you risk losing your money to theft if it is sitting in a shoebox under your mattress. This post on risk vs reward from Mammoth Investor mentions that you also take the risk that banking fees could eat up the interest you expect to receive, wiping out any interest you get.
A fair return on the investment must account for the risk of losing everything, the cost of administering the loan or investment, the interest rate that someone could get in a safer investment and a profit margin on top of that. This is why you routinely find 8% to 12% returns on stocks relative to the 2% to 3% interest paid to savings account holders.
A good comparison is credit card interest rates. If someone has bad credit, the odds they won’t pay back the money they borrowed are higher. They are charged a higher interest rate to make up for the larger proportion of people with bad credit who do not pay back their loans.
You should receive a higher return in exchange for putting your money at risk. However, you could be losing money if you don’t take some risk beyond letting money sit in your bank account. Balance the risk with your risk tolerance and the growth you need to see on your money so that you can achieve your long term goals.