Risk vs Return Explained
Understand the relationship between investment risk and potential returns and learn why higher expected returns usually involve greater uncertainty.
What Is Investment Risk?
Investment risk refers to the possibility that an investment may produce a lower return than expected or lose value.
Different investments have different types and levels of risk.
What Is Return?
Return is the gain or loss generated by an investment over a particular period.
Returns can come from price appreciation, dividends, interest or other forms of income.
A positive return increases the value of an investment, while a negative return reduces it.
The Risk-Return Relationship
Investments with higher potential returns generally involve greater uncertainty or risk.
This does not mean that taking more risk guarantees a higher return. It means investors generally require greater potential compensation for accepting greater uncertainty.
Examples of Different Risk Levels
Cash and certain short-term savings products are generally considered lower-risk compared with individual stocks, although they can still face inflation risk.
Stocks can experience significant price fluctuations, while highly speculative investments can involve even greater uncertainty and potential losses.
The appropriate level of risk depends on the investor's goals and circumstances.
Risk Tolerance vs Risk Capacity
Risk tolerance describes how comfortable an investor is with seeing their investments decline in value.
Risk capacity refers to how much financial loss an investor can realistically withstand without seriously affecting their goals.
These concepts are related but not identical.
Managing Risk
Investors can manage risk through diversification, appropriate asset allocation, realistic time horizons and avoiding excessive concentration in a single investment.
Understanding risk before investing can make it easier to choose a strategy that an investor can maintain during difficult market conditions.