Investing BasicsExplainer
Risk and return explained: why higher potential returns come with bigger risks
Why do riskier investments tend to offer higher potential returns? Learn the risk-return trade-off, the main types of risk and how volatility hurts growth.
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Quick answer
Risk is the chance that an investment loses value or earns less than you expected. Return is what you gain or lose. Investments with more risk tend to offer higher potential returns, because investors demand extra reward for accepting uncertainty, but that reward is possible, never promised.
Key points
- Regulators define risk as uncertainty and the potential for financial loss; every investment carries some.
- Investors demand higher potential returns for taking more risk, which is why stocks have historically returned more than bonds and cash, with bigger swings.
- Two investments with the same average yearly return can end with very different balances if one swings more.
- Losses need larger gains to recover: a 50% fall needs a 100% gain to get back to where you started.
- Diversification, asset allocation and matching money to your time horizon manage risk; nothing removes it entirely.
What do risk and return actually mean?#
Return is what an investment gains or loses over a period, usually shown as a percentage of the money you put in. If $1,000 becomes $1,050 in a year, the return is 5%. If it becomes $950, the return is minus 5%.
Risk is harder to pin down. Investor.gov states that all investments involve some degree of risk and defines it as the degree of uncertainty and/or potential financial loss inherent in an investment decision[1]. FINRA (the Financial Industry Regulatory Authority) puts it as any uncertainty with respect to your investments that has the potential to negatively impact your financial welfare[2].
Both definitions include two ideas. One is the chance of losing money. The other is uncertainty: not knowing which of many possible outcomes you will get. An investment that might return 20% or minus 20% is risky even if, on average, it makes money.
Why do riskier investments tend to offer higher returns?#
Because nobody would accept extra uncertainty for nothing. Investor.gov explains that, in general, as investment risks rise, investors seek higher returns to compensate themselves for taking such risks[1]. FINRA describes the same link: the level of risk associated with an investment or asset class typically correlates with the level of return[2].
You can see the pattern across the three major asset categories. The SEC notes that stocks have historically had the greatest risk and highest returns, bonds are generally less volatile than stocks but offer more modest returns, and cash equivalents are the safest but offer the lowest return[3].
| Asset category | Typical risk level | Typical return level | Main risk to watch |
|---|---|---|---|
| Stocks | Highest of the three | Historically the highest | Large price swings and company failure |
| Bonds | Generally lower than stocks | More modest than stocks | Interest rate changes and issuer default |
| Cash and equivalents | Lowest | Lowest | Inflation eroding buying power |
Summarized from the SEC's beginners' guide to asset allocation[3], Investor.gov's list of risk types[1] and its bond risks, including an issuer failing to pay and defaulting[4]. These are long-run tendencies, not rules for any single year.
What kinds of risk should a beginner know about?#
Risk is not one thing. Regulators list several distinct kinds, and a single investment can carry more than one.
- Business risk. A company can struggle or fail. If it goes bankrupt and its assets are sold, common stockholders are the last in line to share in the proceeds[1].
- Volatility or market risk. Prices move with the market even when the company is fine. Investor.gov notes that large company stocks as a group have lost money on average about one out of every three years[1].
- Inflation risk. Rising prices reduce purchasing power, which is a risk for anyone receiving a fixed rate of interest[1]. Read how inflation affects your money.
- Interest rate risk. When rates change, bond prices move. A bond sold before maturity may be worth more or less than its face value[1].
- Liquidity risk. You may not find a buyer when you want to sell[1].
- Concentration risk. Holding only a few investments increases your exposure to any one of them going wrong; FINRA lists it alongside political and currency risk[2].
Why can two investments with the same average return end up so different?#
Because losses and gains do not cancel out evenly. A year that loses 15% shrinks the base that the next year's gain works on. The more an investment swings, the more this drags on growth, even when the simple average return looks the same.
Worked example
Worked example: steady vs bumpy, both averaging 5% a year
Two hypothetical investments each start with $10,000. The steady one returns 5% every year. The bumpy one returns +25%, −15%, +25%, −15%. Both have a simple average yearly return of 5%. After four years, the bumpy one ends about $866 lower, and its compound annual growth rate is about 3.08%, not 5%.
| End of year | Steady | Bumpy |
|---|---|---|
| Start | $10,000.00 | $10,000.00 |
| End of year 1 | $10,500.00 | $12,500.00 |
| End of year 2 | $11,025.00 | $10,625.00 |
| End of year 3 | $11,576.25 | $13,281.25 |
| End of year 4 | $12,155.06 | $11,289.06 |
Figures computed in code from the stated inputs; rounded to the nearest cent or tenth.
Same average return, different paths
How much harder is it to recover from a loss?#
The percentage gain needed to recover a loss is always larger than the loss itself, because the recovery starts from a smaller base. The bigger the fall, the steeper the climb back. This is why large drops matter so much more than small ones, and why our note on volatility and drawdowns treats the size of the worst fall as a key risk measure.
Gain needed to get back to where you started
Time helps, but it is not a cure. FINRA warns that stocks are always risky investments, even over the long term, and that they don't get safer the longer you hold them[2]. What a long time horizon does give you is room to wait instead of being forced to sell after a fall.
How can you manage risk without avoiding it altogether?#
Avoiding all risk is not really possible: money left in cash faces inflation risk instead. The SEC describes inflation outpacing and eroding returns over time as the principal concern for cash equivalents[3]. The practical goal is to take the kinds and amounts of risk that fit your situation.
Match money to time
Your time horizon is the expected number of months, years or decades you will be investing for a goal[3]. Money needed soon should take little risk; money for distant goals can take more.
Know your risk tolerance
Investor.gov frames it as whether you will be able to sleep at night if you buy an investment that could lose your principal[6]. Read risk tolerance and time horizon.
Spread your money
Diversification can help reduce the overall risk of a portfolio[5]. See diversification explained.
Choose a mix on purpose
FINRA names asset allocation and diversification as basic ways to manage risk[2]. Our asset allocation basics note shows how a mix of stocks, bonds and cash is built.
What mistakes do beginners make?#
Looking only at the average return
An average hides the path. Two investments with the same average can end far apart if one swings more. Look at the worst years as well as the typical ones.
Believing a high return with low risk
If someone offers high returns with little or no risk, treat it as a warning sign, not an opportunity. Real investments that can earn more can also lose more.
Thinking cash has no risk
Insured savings protect the number in your account, not what it can buy. Over many years, inflation can quietly shrink the value of cash.
Taking more risk than you can sit through
A portfolio you sell in a panic after a fall locks in the loss. Choose a level of risk you can stay with during a bad year.
What else do beginners ask?#
Is there any investment with no risk at all?
No. Even insured savings face inflation risk, the chance that prices rise faster than your interest[1]. Different investments simply carry different kinds and amounts of risk.
Does holding stocks for a long time remove the risk?
No. A long horizon gives you time to wait out bad periods, but FINRA notes that stocks do not get safer the longer you hold them[2].
How do I measure an investment's risk?
Common measures include how much its price swings from year to year (volatility) and how far it has fallen from a peak (drawdown). For a beginner, asking 'how much could this fall in a bad year, and could I wait for it to recover?' is a good start.
Does diversification guarantee I will not lose money?
No. Diversification can reduce the damage from any single investment going wrong, but a broad market fall can still lower the value of a diversified portfolio.
What is the bottom line?#
Risk and return are two sides of the same decision. Higher potential returns come with more uncertainty and deeper possible losses, and the arithmetic of losses means big falls take a long time to repair. You cannot remove risk, but you can choose it deliberately: match money to time, spread it across many holdings, and take only as much risk as you could live with through a bad year.
Sources
Numbers in brackets in the text point here. Grade A = primary source (regulator, statistics agency, law or official document).
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