Risk and Return
Understanding the Trade-offs
Introduction
In investing, risk and return are fundamentally linked. Higher potential returns come with higher risk of loss. Understanding this relationship—and your own tolerance for risk—is essential for building a portfolio that you can stick with through market ups and downs.
This lesson explores different types of investment risk, how to assess your risk tolerance, and how diversification can help manage risk without sacrificing too much return.
The Risk-Return Relationship
The Fundamental Trade-off:
Investments offering higher potential returns generally carry higher risk of loss. This isn't a flaw—it's a feature. If risky investments didn't offer higher returns, no one would take the risk.
| Investment Type | Risk Level | Historical Return | Volatility |
|---|---|---|---|
| Savings Account | Very Low | ~0.01-5% | None |
| Government Bonds | Low | ~4-5% | Low |
| Corporate Bonds | Medium | ~5-7% | Medium |
| Stock Index Funds | High | ~10% | High |
| Individual Stocks | Very High | Varies | Very High |
| Cryptocurrency | Extreme | Varies | Extreme |
Key Insight:
You cannot get high returns without accepting risk. Anyone promising high returns with no risk is lying or running a scam.
Types of Investment Risk
Market Risk (Systematic Risk)
The risk that the entire market declines. During the 2008 financial crisis, nearly all stocks fell. You cannot diversify away market risk.
Company Risk (Unsystematic Risk)
The risk of a specific company failing. Enron shareholders lost everything while the broader market survived. Diversification reduces company risk.
Inflation Risk
The risk that your returns don't keep pace with inflation. A "safe" investment earning 2% while inflation is 3% loses purchasing power.
Interest Rate Risk
When interest rates rise, bond prices fall. Long-term bonds are especially sensitive to interest rate changes.
Liquidity Risk
The risk of not being able to sell an investment when you need to. Real estate can be hard to sell quickly.
Sequence Risk
The risk of market drops occurring at the worst time (like right before or during retirement). The order of returns matters, not just average returns.
Understanding Your Risk Tolerance
Risk tolerance is your ability and willingness to endure investment losses. It has two components:
Risk Capacity:
Your objective ability to take risk based on:
- Time horizon (how long until you need the money)
- Income stability
- Other resources and savings
- Financial obligations
A 25-year-old with stable income and 40 years until retirement has high risk capacity. A 60-year-old retiring in 5 years has low risk capacity.
Risk Willingness:
Your emotional comfort with volatility:
- Can you sleep when your portfolio drops 30%?
- Would you panic and sell at the bottom?
- Does market volatility cause you stress?
Someone might have high risk capacity but low risk willingness—or vice versa.
Your effective risk tolerance is the lower of these two.
Assessing Your Risk Tolerance
Consider these scenarios honestly:
Scenario 1: Your portfolio drops 20% in one month. Do you:
- A) Sell to prevent further losses
- B) Do nothing and wait it out
- C) Buy more at lower prices
Scenario 2: You need this money in:
- A) Less than 3 years
- B) 3-10 years
- C) More than 10 years
Scenario 3: Which describes your investment goal best:
- A) Preserve capital at all costs
- B) Balance growth and stability
- C) Maximize long-term growth, accepting volatility
More A answers = lower risk tolerance More C answers = higher risk tolerance
Diversification: Reducing Risk
Diversification means spreading investments across different assets so that poor performance in one area doesn't devastate your entire portfolio.
Why It Works:
- Different assets often move independently
- When stocks fall, bonds often rise (or fall less)
- When US markets struggle, international markets may do well
- No single investment failure ruins your portfolio
Types of Diversification:
| Type | Example |
|---|---|
| Across asset classes | Stocks + Bonds + Real Estate |
| Within asset classes | Large + Mid + Small cap stocks |
| Geographic | US + International + Emerging markets |
| Sector | Technology + Healthcare + Finance |
| Time | Dollar-cost averaging (buying regularly) |
Important Note:
Diversification reduces risk but doesn't eliminate it. In severe market crashes, correlations increase and most assets fall together.
Asset Allocation
Asset allocation is how you divide your portfolio among different asset classes. It's the most important investment decision you'll make—more important than which specific stocks or funds you choose.
Common Guidelines:
A traditional rule of thumb: "Your age in bonds, remainder in stocks"
- Age 30: 30% bonds, 70% stocks
- Age 60: 60% bonds, 40% stocks
Modern Approach:
Many experts suggest more aggressive allocations when young:
- Age 30: 10-20% bonds, 80-90% stocks
- Age 50: 30-40% bonds, 60-70% stocks
- Age 65: 40-50% bonds, 50-60% stocks
Sample Allocations by Risk Profile:
| Profile | Stocks | Bonds | Cash |
|---|---|---|---|
| Aggressive | 90% | 10% | 0% |
| Moderate | 60% | 35% | 5% |
| Conservative | 30% | 60% | 10% |
Rebalancing
Over time, different investments grow at different rates, shifting your allocation. Rebalancing returns your portfolio to target allocations.
Example:
- Target: 70% stocks, 30% bonds
- After market rise: 80% stocks, 20% bonds
- Rebalance: Sell stocks, buy bonds to return to 70/30
How Often:
- Calendar-based: Annually or quarterly
- Threshold-based: When allocation drifts more than 5%
- Combination: Check quarterly, rebalance if needed
Why It Matters:
Rebalancing forces you to sell high and buy low, maintaining appropriate risk levels.
Key Takeaways
- Higher potential returns come with higher risk—this is fundamental to investing
- Risk types include market risk, company risk, inflation risk, and sequence risk
- Your risk tolerance combines capacity (objective factors) and willingness (emotional comfort)
- Diversification reduces risk by spreading investments across different assets
- Asset allocation—how you divide between stocks, bonds, etc.—is your most important investment decision
- Rebalancing maintains your target allocation and risk level over time
Summary
Risk and return are inseparable in investing—higher potential returns require accepting higher risk. Understanding the types of risk (market, company, inflation, sequence) helps you make informed decisions. Your risk tolerance depends on both objective factors (time horizon, income) and emotional factors (can you handle volatility?). Diversification reduces risk by spreading investments across asset classes, geographies, and sectors. Asset allocation—your mix of stocks, bonds, and other assets—is more important than individual investment choices. Regular rebalancing maintains your target risk level as markets move.