5.7 Risk and Return

Risk and Return Go Hand in Hand

Risk is the chance an investment's actual return differs from what's expected, including losing money. Return is the gain or loss on an investment over time. Generally, higher potential return requires accepting higher risk — this is the risk-return tradeoff. Investors demand extra reward for taking on extra uncertainty.

Types of Investment Risk

Market risk comes from overall economic swings affecting most investments. Inflation risk is the chance rising prices erode purchasing power. Liquidity risk means an asset can't be sold quickly without a loss. Diversification — spreading money across different asset types — reduces risk without necessarily sacrificing return.

Matching Risk Tolerance to Goals

Risk tolerance is a person's willingness and ability to endure investment losses, shaped by age, income, and goals. Younger investors with long time horizons can typically accept more risk since they have time to recover from downturns. Conservative investors favor safer assets like bonds or savings accounts over volatile stocks.

Key terms

Risk-return tradeoff

The principle that higher potential returns generally require accepting higher risk.

Diversification

Spreading investments across different asset types to reduce overall risk.

Liquidity risk

The risk that an asset can't be sold quickly without losing significant value.

Risk tolerance

An individual's willingness and financial ability to handle investment losses.

Time horizon

The length of time an investor expects to hold an investment before needing the money; longer horizons often allow more risk-taking.

Try an AP-style question

The risk-return trade-off means…

1. low-risk investments pay the most
2. higher returns mean lower risk
3. risk and return are unrelated
4. higher potential returns bring higher risk