What is the Relationship Between Risk and Return in Investing?

The whole point of investing is to grow your money as much as possible within a given period of time. Whether you are looking ahead to retirement, a down payment on a home, a child’s future college expenses or something else entirely, investing has the potential to help you reach your financial goals a lot quicker than if you were to simply save your money.

But most financial advisors will tell you that it isn’t enough to grow your money as much as possible, as quickly as possible. Because every investment carries certain risks, you should also aim to do so as safely as possible.

Here, we explore investment risk and the relationship that it often has with return.

What is risk?

Financially speaking, risk refers to the potential for loss that comes with any investment decision. Because there is no such thing as a “guaranteed” investment, all investments will involve at least some risk.

Financial risk comes in a number of flavors. Some of the most important for investors to consider are:

Business Risk

This refers to the risk that the company you are investing in may go out of business, in which case you may lose some, or all of, your investment. Younger companies are often seen as riskier than more established companies, because they do not have as long a track record for investors to consider.

Volatility Risk

Nearly all investments will fluctuate in value—sometimes up, sometimes down. Volatility is a measure of how much, and how often, an investment’s value fluctuates. Investments that experience greater volatility are seen as riskier than more stable investments because there is the risk that when you need your money, you may be forced to sell when the value of your investment has dropped.

Liquidity Risk

In order to cash out of an investment, an investor must find someone who is willing to purchase the investment from them. If the investor cannot find a buyer, then the value of the investment is trapped inside of it. Certain investments (such as stocks and bonds) are seen as more liquid than other investments (like real estate). The risk is that if you need to access the value of your investment, but cannot find a buyer, you may be forced to lower your selling price in order to entice a buyer.

Inflation Risk

Even the “safest” of investments come with their own risks. For example, it’s true that if you put money in a savings account, you won’t lose any of the capital (or money) that you put in; in fact, you will likely wind up with more money as your funds accrue interest. But if inflation—the rate at which prices rise—outpaces the interest that your savings earn, you could still find yourself with less buying power than you originally had. (As of mid-2019, the annual inflation rate is just under 2 percent.) All investments involve inflation risk.

What is the relationship between risk and return?

You may be wondering: Why would anybody invest in a risky investment if there are safer investments to choose from? The answer is that, in order to attract investors, riskier investments typically offer a higher potential for profit.

Think about it. Let’s say that, as an investor, you were given the choice between investing in two companies. Company A has been in business for over 100 years and has proven itself stable and profitable over the long term. If you invest in Company A, experts tell you there is a 5 percent risk that you will lose your money. Company B, on the other hand, has only been in business for 1 year, and it has yet to turn a profit. If you invest in Company B, there is a 50 percent risk that you will lose your money.

If both Company A and Company B offered the same return on investment, you would of course choose the “safer” investment—Company A—because there is no incentive to take on additional risk.

But now let’s say that an investment in Company A carries a potential ROI (or return on investment) of 2 percent, while an investment in Company B carries a potential ROI of 20 percent. The potential for a greater return just might tempt you to take on some additional risk.

Investments Ranked by Risk

It’s worth repeating that no investment comes without risk. That being said, certain investments are generally held to be riskier than others. Below are three of the most common types of investments, ranked from least risky to riskiest.

Certificates of Deposit (CDs) and Other Cash Equivalents

If you invest in CDs, you are extremely unlikely to lose any of your principle. But while your investment will never go down to zero, there are other risks to consider: Inflation could grow faster than the interest you receive, eroding your purchasing power. And if an emergency pops up, you could be forced to cash out of your CD early, which could bring penalties.

Bonds

Byonds are essentially loans that you make to either a company or government in exchange for interest payments.

The amount of interest you can expect to earn from a bond is determined by the credit worthiness of the entity that issues the bond (or IOU). If a company has a very good credit rating, it is unlikely to renege on its debt. This means that there is less risk involved in the investment, which generally translates into lower interest rates. The opposite also holds true: A company with a poor credit rating might not be able to pay back its debt, increasing the risk of the investment and, therefore, the amount of interest you can expect to earn. Bond ratings firms like Standard & Poor’s, Moody’s and Fitch issue different ratings—typically, upper- and lower-case As and Bs—to designate a bond’s credit quality.

Generally, government bonds are viewed as being the lowest risk, followed by investment-grade corporate bonds. (An investment grade is a rating that signifies the corporate bond possesses a relatively low risk of default.) The primary risks involved in investing in bonds are inflation, as well as the risk that a company goes out of business and is unable to pay you back.

Stocks

By investing in stocks, you are purchasing shares of a company. The value of these shares is based upon the overall financial health of the company (or companies) that you are invested in, as well as other factors, like the health of the economy as a whole.

In the short term, stocks are generally viewed as riskier than bonds because of how quickly their value can fluctuate. Quarterly earnings reports, political developments, even bad weather can all affect the stock market. That being said, every stock market downturn has eventually ended in an upturn. Over the long term, the stock market has risen significantly.

When investing in stocks, it is important to note that not all companies are the same. Newly-established companies with less of a track record are generally viewed as riskier than well-established companies, for example. But because the newer company has so much room for growth compared to the more established company, some investors may be willing to take on this risk.

Determining How Much Risk is Right for You

So how much risk should you accept in your investments?

Unfortunately, there is no one-size-fits-all answer. The specific amount of risk that you’re willing to take on can be based on a number of factors:

Your financial goals

By understanding your financial goals, as well as your current reality (i.e., how much money you have to invest on a weekly or monthly basis), you can determine how much risk you will need to accept in order to realistically reach those goals. Generally speaking, the more money you have to invest, the less risk you will have to take on to reach your goals.

Your investment timeline

Your investment timeline, or investment horizon, refers to how much time you have before you will need your money. Generally speaking, if you have a longer investment timeline, you can afford to take on more risk in your investment plan, because you can ride out short-term volatility and have more time to recover if investments lose value. If you have a short investment timeline, you have less time to make up lost value and, therefore, will typically want to assume less risk.

Your tolerance for risk

Risk tolerance refers to the amount of risk that you, personally, can stomach with your investments. If you have a high tolerance for risk, you might be comfortable assuming much more risk than someone with a low tolerance for risk (or vice versa).

These three factors considered together should form the basis of how much risk your investments carry.

Managing Your Investment Risk

Remember, it is risky to put all of your money into a single investment. Every investment carries risk, and your job as an investor is to manage that risk.

The best way to manage your risk and protect yourself is to practice proper diversification. You can do this by splitting your money between different asset classes (by investing in stocks, bonds, etc.) as well as within each asset class (by investing in multiple types of companies and sectors, for example).

One of the easiest ways of diversifying your investments is to invest in low-cost exchange-traded funds (ETFs), which can include several stocks, bonds or commodities and provide near-instant diversification.

Find out more about investing with Acorns.