Risk vs Return: Understanding the Relationship Between Investment Risk and Returns
Risk and return are two important concepts in investing. Every investment can involve some level of uncertainty, while returns represent the gains or losses that may result from an investment over time.
What Is Investment Risk?
Investment risk refers to the possibility that the actual outcome of an investment may differ from what an investor expects. This can include the possibility of earning lower returns than expected or losing part or all of the invested amount.
Different investments can involve different types and levels of risk. Risk can also change over time as market conditions, economic factors and the circumstances of an investment change.
Risk is the uncertainty around an investment's future outcome. Return is the gain or loss that results from the investment.
What Is Investment Return?
Investment return is the change in value that an investor experiences from an investment. A return may come from an increase or decrease in the value of an asset, income received from the investment, or a combination of both.
Returns can be positive, negative or zero. Past returns do not guarantee future performance.
How Are Risk and Return Connected?
In general, investments with the potential for higher returns may also involve greater uncertainty and a greater possibility of losses. However, higher risk does not guarantee higher returns.
An investment may carry significant risk and still produce poor results. Understanding this distinction is important when evaluating investment opportunities.
Two investments may have different levels of price volatility. The investment with larger price movements may offer the possibility of higher gains, but it may also experience larger losses.
Common Types of Investment Risk
- Market risk: The possibility that overall market conditions may affect investment prices.
- Inflation risk: The possibility that rising prices reduce the purchasing power of money and investment returns.
- Interest rate risk: Changes in interest rates may affect the value of certain investments.
- Credit risk: The possibility that a borrower or issuer may fail to meet financial obligations.
- Liquidity risk: The possibility that an investment may be difficult to sell quickly at an acceptable price.
- Concentration risk: The risk of having too much exposure to a single investment, sector or asset type.
Risk Tolerance
Risk tolerance refers to an investor's ability and willingness to accept uncertainty and potential losses. Financial circumstances, investment objectives, income stability and time horizon may influence how much risk an individual is comfortable taking.
Two investors can have different risk tolerances even when considering the same investment.
The Importance of Time Horizon
An investment time horizon is the expected period before an investor may need to use the invested money. Time horizon can influence how an investor evaluates potential price fluctuations and investment risk.
Short-term financial needs may require different considerations from long-term goals. However, a longer investment period does not eliminate the possibility of losses.
Can Diversification Reduce Risk?
Diversification involves spreading investments across different assets, sectors or investment types. It may help reduce the impact of problems affecting a single investment or area of the market.
However, diversification cannot eliminate all investment risk. Broad market declines and other factors can still affect diversified portfolios.
Why Understanding Risk Matters
Investors may focus heavily on potential returns while overlooking the possibility of losses. Understanding the risks involved can help investors make more informed decisions and evaluate whether an investment is suitable for their objectives and circumstances.
Investment decisions should consider more than past performance or expected returns. Costs, liquidity, time horizon, diversification and personal financial circumstances can also be important.
Key Takeaways
- Risk refers to uncertainty and the possibility of financial loss.
- Return represents the gain or loss from an investment.
- Higher potential returns can involve greater uncertainty, but higher risk does not guarantee higher returns.
- Different investments can involve different types of risk.
- Diversification may reduce certain risks but cannot eliminate all investment risk.
- Time horizon and personal circumstances can influence investment decisions.