Introduction to Corporate Finance

6: The Trade-Off Between Risk and Return

PLANNING FOR YOUR RETIREMENT

Sooner than you expect, you’ll graduate from

university and enter the workforce. When you do,

your employer will need to make contributions to

your superannuation account, and you will have

to decide how to allocate this between different

investment options. Suppose you plan to work for

35 years, and each year you will contribute $4,000

to your superannuation account. We’ll assume that

these contributions occur annually starting one year

from now. We will use the equation for the future

value of an annuity from Chapter 3 to estimate how

much money will accumulate in your account by

the time you retire, exactly 35 years from now. The

answer will depend on how you invest.

You can invest your money in either equities or

bonds. Suppose that over the next 35 years, the

equities earn an average annual return of 11.4% and

bonds earn 5.6% annually (equal to their respective

historical averages). The following table illustrates

the superannuation account value in 35 years under

three different investment allocation scenarios. The

first scenario assumes you invest all contributions in

equities. The second assumes you invest exclusively

in bonds, and the third assumes you split your

contributions evenly between equities and bonds.

It should not surprise you that the more money you

invest in equities, the greater is the future value of

your retirement account. For example, if you invest

everything in equities, then by using Equation 3.4,

we can calculate the account value in 35 years as

follows:

FV= $4, 000

(1+0.114) -1

0.114

= $1,500, 013

35

×













Allocation decision Account value in 35 years

100% equities $1, 500,013

100% bonds $409,532

50% in each $954,772

From the table, it might seem that investing

all your money in equities is obviously the best

thing to do. However, there is no way for you to

guarantee that your investments in equities will earn

the historical average return, as our calculations

assume. Consider what might happen if, in the

years just before you retire, the return on the stock

market is unusually low, as happened several times

in the 1930s and as recently as 2008. In that case,

the value of your investment account could fall by

hundreds of thousands of dollars right before you

need to start drawing upon those funds. Thus, the

investment allocation decision involves an inevitable

trade-off between the prospect of higher returns

and the perils of higher risk.

This is borne out by the Australian data in

Table 6.3, which shows how returns for different

asset classes have varied substantially over different

time periods leading up to 30 June 2015.

finance in practice

CONCEPT REVIEW QUESTIONS 6-2

3 Why do investors need to pay attention to real returns as well as nominal returns?

4 Look at Figure 6.3a. The figure is drawn using a logarithmic vertical scale, which means that if an

investment offers a constant rate of return over time, the growing value of that investment would

plot as a straight line. This implies that the steeper the line is, the higher is the rate of return on the

investment. Given this, which investment looks like it performed best in real terms from 1920–30?

What about from 2000–2010?

5 In Table 6.1a, why are the average real returns lower than the average nominal returns for each

asset class? Is it always true that an asset’s nominal return is higher than its real return?