Risk and return: two sides of one coin
Higher potential reward almost always comes with a bumpier ride.
No free lunch
In investing, risk usually means uncertainty: the chance that your result is very different from what you expected, including losing money. Return is what you gain or lose.
The core idea: investments that offer higher potential returns usually come with more risk. If something offered high returns with no risk, everyone would buy it until the price rose and the return disappeared. So anyone promising high returns with no risk deserves suspicion.
A ladder of risk
Picture a ladder. At the bottom: insured savings and Treasury bills, with low, steady returns. In the middle: bonds, which usually swing less than stocks. Near the top: a broad mix of stocks. At the very top: single stocks, crypto and other speculative bets, which can soar or crash.
Over the long run, US stocks have returned roughly 7% a year after inflation on average, with big swings and no guarantee. Treat that as an illustrative figure, not a forecast. The S&P 500 fell more than 50% from its 2007 peak to its 2009 low, and about a third in a few weeks in early 2020. Average returns hide years like those.
Your risk is personal
How much risk makes sense depends on your time horizon, how stable your income is and how you would feel and act if your investments dropped 30%. Someone who would panic and sell at the bottom may be better off with a calmer mix they can stick with.
Investment A earns 5% every year. Investment B earns +25%, then -15%, alternating.
Start with $1,000. After two years, A has $1,000 x 1.05 x 1.05 = $1,102.50. B goes to $1,250, then down 15% to $1,062.50.
B's simple average is 5% a year, the same as A, yet B ends with less. Big swings drag on results, and they test your nerves.
Key terms
- Risk
- The uncertainty of an investment's outcome, including the chance of losing money.
- Volatility
- How much and how quickly an investment's price moves up and down.
- Risk tolerance
- How much ups and downs you can handle, both financially and emotionally, without abandoning your plan.
Higher potential return comes with higher risk; anyone offering one without the other is a red flag.