Risk vs. reward: The first step toward measuring and managing risk
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Risk versus reward—it’s perhaps the toughest challenge in all of investing.
Wouldn’t it be great if the least risky investments were also the safest? Too bad the world doesn’t work that way. Assets that are considered safer usually pay lower returns, and those that are riskier may pay higher returns. Why? Because potential reward is the enticement for taking on higher risk.
Are you considering making an investment, but unsure if it’s worth the risk? Here’s a general framework for analyzing the relative riskiness of stocks and bonds.
Key Points
- Risk and reward go hand in hand, so it’s important to find that investing sweet spot.
- The Cboe Volatility Index (VIX) is one way to measure the current risk in the overall market.
- Beta measures individual stock (or ETF) risk against a benchmark such as the S&P 500 Index.
- Moody’s, Fitch, and S&P are among the firms that issue bond ratings.
The risk vs. reward trade-off
Generally, investors tend to be risk averse. Their goal is to achieve the highest possible expected return while carrying an acceptable risk. When the markets are rising and everyone’s eager to own those glamor stocks, the chances of achieving this objective may be higher. But the markets don’t always rise. And sometimes, when they fall, they fall quickly and violently.
Financial markets can be vulnerable. Any sign of fear—inflation, geopolitical tensions, an economic downturn—can create uncertainty for investors and lead them to sell off their investments. And when all investors head to the exits at the same time, the selling pressure drags stocks down even more, creating a vicious cycle.
That’s volatility. That’s risk.
But what about reward? Let’s look at the two traditional asset classes: stocks and bonds. Historically, stocks have had higher returns than bonds over the long term. Since the Great Recession (2007–09), average annual returns from U.S. stocks were 10.32% (as of 2022). Average annual returns from treasury bonds were 5.79%.
That’s a solid baseline to measure potential returns. From there, you can drill down into the specifics of any individual investment. In the case of stocks, that would be company earnings and other fundamental metrics. For bonds and other fixed-income investments, it would be the current yield.
But returns from stocks and bonds aren’t guaranteed, and both carry risks. How can you analyze those risks?
Stock risk vs. reward: VIX and beta
In general, there are two different ways to look at stock market risk:
- How much risk is expected in the overall market?
- How much risk is expected in a specific stock or exchange-traded fund (ETF) relative to the overall market?
If you’re looking at investing in an index fund, it’s important to consider the first question. If you’re looking at specific symbols, consider both questions.
Overall market volatility: Monitor the VIX
You can track the volatility of the overall market by monitoring the Cboe Volatility Index (VIX). The VIX indicates the amount of volatility expected in the S&P 500 Index (SPX) over the next 30 days, as measured by the volatility implied by option contracts on the SPX.
When markets are extremely volatile—particularly to the downside—the VIX tends to spike, which is why it’s often called the market’s “fear gauge.” In general, a VIX reading below 20 indicates a relatively calm or complacent market. But when the VIX starts moving above 20, it’s an indication of nervousness. The higher it goes, the more nervous the market.
A high VIX can make investors uncomfortable and lead them to sell their investments. During the Great Recession of 2007–09, and again during the COVID-19 scare in March 2020, the VIX spiked above 80. The Dow Jones Industrial Average (DJIA) experienced a 49% drop during the Great Recession and a 37% decline during the COVID crash.
The VIX changes throughout the trading day, much like a stock price. Most services that provide stock quotes publish the VIX value, too. As an investor, it’s a good idea to monitor the VIX, since it can alert you when the market might be getting jittery.
Now that you know how to assess the riskiness of the overall market, how can you compare the risk of an individual investment to the market? This is where beta can help.
Single investment: Use beta to measure investment risk
Beta looks at the correlation of an asset with a market benchmark such as the S&P 500 Index (SPX). High-beta stocks are considered more volatile than the broader market, and low-beta stocks are less volatile. Stocks that move more than the market are described as having high beta, whereas stocks that are less volatile than the market are considered low-beta stocks. So, you might earn higher returns from higher-beta stocks, but you’d be taking on more risk.
You can find out a stock’s beta from most services that provide financial quotes. Here’s how it works:
- The beta of the SPX is 1.0.
- Generally, if the beta of an investment is between 0 and 1, it’s likely to be less risky than the market.
- If beta is greater than 1, it means the stock is riskier than the market. For example, if a stock has a beta of 2.0, it suggests that if the rate of return on the SPX increases or decreases by 1%, then the estimated return in the stock would increase or decrease by 2%.
Beta isn’t precise—not on a daily basis, anyway—and it can change over time. Still, it’s a good starting point for assessing the relative risk of a single security.
Good to know
Want to dive deeper? Here’s a list of the types of investment risk you might encounter.
Riskiness of bonds
In general, bonds and other fixed-income investments are considered “lower risk” than stocks, but there are still risks associated with fixed-income investing.
Beyond the bond’s price risk—bond prices fluctuate daily, just like stocks—there’s another big risk specific to bonds: default risk, which is the risk that the issuer might be unable to meet its obligations (that is, paying you interest and paying back your principal).
Some bonds are riskier than others. And, once again, the riskier bonds tend to pay a higher interest rate to entice investors to assume that extra risk. Looking for a general overview of the riskiness of a particular bond? This is where rating agencies come in.
Bond ratings indicate the risk you’d be facing if you were to own the debt of the bond issuer. The three big bond rating agencies—Moody’s, S&P Global Ratings (formerly known as Standard & Poor’s Rating Services), and Fitch Ratings—follow a similar hierarchy when rating bonds. But they use a slightly different classification system. For example, Moody’s highest rating for investment-grade bonds is Aaa, while S&P Global Ratings and Fitch rate them as AAA.
Bond ratings generally fall under two broad categories: investment-grade and high-yield. (High-yield may also be called non-investment-grade or junk bonds.)
- Investment-grade bonds. These are rated Baa3/BBB- or better and considered less risky.
- High-yield bonds. These are rated Ba1/BB+ and lower and considered to be more risky.
Generally, bonds that have a lower credit ranking indicate a higher risk potential and command a higher yield. Bonds with a higher credit rating indicate more stability and generally provide a lower yield.
The bottom line
Analyzing investments from a risk-versus-reward perspective can help you decide if they’re right for you. But risk isn’t static. It changes when market dynamics change, which is why you should monitor volatility and beta for equity investments, and bond ratings for fixed-income investments. They give you a general idea of the risk levels.
But remember: These risk measures are general numbers. Each investment you’re considering has its own unique set of risks.
Plus, risk is only half of the risk/reward equation. There’s another array of metrics—called fundamental analysis—to help you analyze the “reward” part.