How to get higher investment returns with low risk

High risk doesn't always mean you should expect higher returns, nor low risk, lower returns when it comes to investing your cash.

“Generally speaking, the higher the rate on an investment the more risky it is.”

In some ways, you can't argue with Danny Cox, financial planner for Hargreaves Lansdown, writing for unbiased.com.

If someone is promising a “once in a lifetime” investment (to quote a recent FSA press release about investment fraud), or boasts returns of 10%, 20% or even 1,000% per year, you need to be extremely sceptical. Such promises are often scams and, of those that aren't, they will be either high risk or high cost, which often amounts to the same thing.

Even if these schemes don't lose you your entire investment, you should be prepared to be massively disappointed by them.

When higher reward has lower risk

You still need to be careful how you interpret Cox's general comment, however. It's certainly not always true that higher reward comes with higher risk.

You could, for example put your money into two different but similar investment funds, one inside and one outside a pension. The pension fund brochure will probably forecast a 7% return (before costs) and the non-pension fund brochure just 6%.

The financial regulator is on the verge of lowering both of these figures by about one percentage point, but the nub is that the people investing in the very tax-efficient pension have lower risk than those investing in a similar fund in a taxable non-pension plan.

In this case, it's clear that the higher projected pension return does not come with higher investment risk.

Aim too low and your risk climbs again

Let's sink much lower down the scale to savings accounts and bank accounts, which have very low projected returns, and therefore should be extremely low risk.

Most people who keep their money in cash lose to inflation in the long run by a very large margin. In other words, in real terms, they very definitely lose money. That's hardly low risk in my opinion.

Compare that to investing in a diverse basket of shares, which have much higher projected returns – and therefore should be more risky than cash, if the rule is true.

However, unlike cash, shares usually do beat inflation in the long run, and they're even more likely to beat the average returns of people investing in cash. So you get higher probable reward with lower risk.

A lot of risk is in our heads

If someone investing in cash should expect to lose money, while someone investing in shares should usually expect to win, it's strange that cash is called low risk and shares high risk. Yet, although it can be terribly misleading, there are important reasons for it.

Cash probably won't scare you by falling 50% in value in one year. Shares probably will, and more than once in your investing lifetime. The point to get from this is that, if you're not measuring your investing horizons in decades, shares probably really are higher risk than cash.

For long-term share investors, the big risk is psychological. Stock market crashes should be irrelevant if you're in it for the long haul – in theory. But, in practice, private investors who really believed they could handle volatility still usually end up buying high and selling low, and not having the courage to buy back in until shares are expensive again.

It's hard to resist this behaviour when, during crashes, every newspaper, blog and financial commentator is doing their best headless chicken impression, while banging on about the end of the world, day after day after day. Repeating history's mistakes for the umpteenth time.

Hitting the sweet spot

So, you see, the rule of low risk/low return and high risk/high return is a generalisation that often isn't up to scratch. It doesn't explain enough.

In my opinion, the sweet spot of risk and reward is a spread between a particular type of savings product and low-cost, diversified stock-market investments.

Savings products like National Savings & Investments' index-linked savings certificates (currently not on sale) and BM Savings' inflation rate ISAs are possibly the lowest-risk investment products in the country due to their inflation-matching (or beating) guarantees. Despite being extremely low risk, the relatively few people using them - and savings products like them - are likely to beat both inflation and the vast majority of other savers over the long run.

When compared to those savings products at least, shares do fit the general rule of higher risk, higher reward. If you invest regularly in the stock market, focusing on keeping the costs down and diversifying, and if you're prepared to invest for a very long time, and you keep your head during crashes (you rare beast, you!) you're likely to do better than those in inflation-beating savings products. But the extra risk means you might not.

In between those investments, we also have the likes of Zopa, Ratesetter and Funding Circle.

More on investing:

Wine investments: how to avoid the £100m scammers

Structured products are still best avoided

Who wants to be a millionaire? Five boring ways to make a million

How to buy gilts

Bonds smash shares