18 December 2023

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Returns Between Expectations and Uncertainty

Luigi Campopiano

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Moving in the markets also means being willing to accept a certain margin of uncertainty: generally, the higher it is, the higher the potential return on your investments. A fundamental variable in the realm of savings and investments is risk (the share of inherent uncertainty intrinsically linked to a specific financial activity).

A specific financial activity is defined as risky when its performance cannot be entirely or at least partially predicted in advance with certainty. Conversely, it is considered low risk and/or risk-free if its performance over time is more easily predictable and/or is capable of guaranteeing a certain cash flow, exposing itself to a lesser extent to the possibility of fluctuations or losses. In simpler terms, an investment is low risk when it ensures at least the preservation of the initial capital for the saver, whereas it is high risk when determining the final extent of the invested capital becomes more challenging (it may even incur significant losses).

Why risk to the point of jeopardizing the invested sum? Is it worthwhile to expose oneself to adverse or difficult-to-tolerate situations? Another fundamental concept in the financial domain comes into play here: return (usually, risk and expected return grow proportionally). Those aiming to increase their initial capital must be willing to take on some additional risk, implementing all strategies useful for containing these risks (e.g., investment diversification), but at the same time being cautious of claims regarding strategies or solutions that promise quick enrichment without any danger.

Savers/investors engaged in financial activities typically do so with the expectation that these activities will yield a positive return (a profit with a plus sign). Setting realistic return goals, risk is the "price" one is willing to pay to preserve (e.g., from inflation erosion) or increase their initial capital. It is, therefore, a difficult-to-quantify entity (unlike returns) and, above all, subjective: risk tolerance (the willingness to bear the non-achievement of set goals or even losses) depends on the financial profile of each saver/investor (taking into account their age, goals, economic and financial availability, etc.).

To evaluate one's risk tolerance, there are no exact formulas, but some common-sense practices can be employed:

• Taking into account both one's current economic situation and future income prospects in the short and medium term can help quantify the percentage of invested capital one is willing to lose in a certain period (considering one's investment time horizon). This does not mean that the scenario must actually turn out unfavorable; it means defining a "benchmark" in the case of challenging markets.
• Carefully assessing the risk of the chosen instrument, avoiding hasty or superficial judgments. Personal factors come into play (e.g., past experiences, personal level of financial literacy, one's character, personal capacity to withstand adversities, etc.). Seeking the support of a professional who provides all the necessary information for thoughtful and informed choices and avoids decisions or changes in plans dictated by emotional difficulties in tolerating risks is useful.

Talking about financial risk only in terms of inclination or evaluation is still limited: another fundamental concept is that of risk management (the set of activities that can be implemented to try to control potential uncertainty factors, seeking to limit adverse events and maximize returns). Financial risks should not only be taken into account but can also be professionally managed through adequate planning, which will depend on both assessments and precautions regarding the individual strategy pursued and the decision to rely on multiple activities or instruments that function as a system of checks and balances in the pursuit of the delicate risk-return balance.