Risk and Return

Why this matters

Every investment choice is partly a choice about risk. If you know what risk means and how it connects to return, you can judge any investment by asking two questions: what could I earn, and what could go wrong? Much of the rest of the curriculum is built on those two questions.

What risk means

In everyday speech, risk means the chance of something bad happening. In investing, risk is broader: it's the chance that results turn out different from what you expected. That includes doing worse than expected, and it includes losing money.

It helps to separate two kinds:

• Price swings. Many investments move up and down in value from day to day and year to year. How much they move is called volatility. A drop you can wait out is uncomfortable, but it isn't a loss until you sell.
• Permanent loss. Sometimes money is gone for good: a company goes bankrupt, or you sell after a drop and the investment never recovers. That's a permanent loss of capital, and it's the kind of risk that matters most.

The two are linked. Large price swings can turn into permanent losses if you have to sell at the bottom, which is why Are You Ready to Invest? focused on never being forced to sell.

Why more risk comes with more potential return

Imagine two investments that are both expected to earn 4% a year. One is very stable. The other could rise 30% or fall 30% in any given year. Which would you buy?

Almost everyone picks the stable one. To persuade people to hold the risky one, it has to offer the chance of earning more. So in practice, investments with bigger swings tend to be priced so that their potential return is higher. That's the basic relationship between risk and return: investors expect to be paid for taking on uncertainty.

Look at the width of each bar rather than its right end. Moving down the chart, the best case gets better, and the worst case gets much worse. That's the trade you make when you reach for higher potential returns.

A worked example: same average, different ending

Two investments each start with $10,000 and each average about 6% a year over four years. One earns a steady 6% every year. The other swings.

Year	Steady: return	Steady: value	Bumpy: return	Bumpy: value
Start		$10,000		$10,000
1	+6%	$10,600	+25%	$12,500
2	+6%	$11,236	−15%	$10,625
3	+6%	$11,910	+20%	$12,750
4	+6%	$12,625	−5%	$12,113

The bumpy investment's yearly returns average slightly more than 6%, yet it ends about $500 behind. Losses hurt more than equal gains help: after a 15% drop, you need a gain of almost 18% just to get back to where you were. After a 50% drop, you need 100%.

This is why an average return on its own never tells the whole story. Two investments can share an average and give very different experiences, and very different endings.

How risk is measured

Risk can't be seen directly, so investors use measurements that describe past behavior. Two come up constantly:

• Standard deviation. A number describing how spread out returns have been around their average. An investment with an average return of 7% and a standard deviation of 15% has had much wider swings than one with the same average and a standard deviation of 5%. Higher standard deviation means higher volatility.
• Drawdown. The fall from a peak to a later low, such as "down 35% from its high." The largest one over a period is the maximum drawdown. It answers a question most people care about more than any statistic: how bad did it get?

Both describe the past, and the past is only a rough guide to the future. They also miss things: standard deviation treats a surprise jump up the same as a surprise drop, and neither one tells you whether a loss was temporary or permanent. The Portfolio Theory and Risk depth track covers these measures, and their limits, in detail, starting with Expected Return and Standard Deviation.

Some risk can be reduced

Not all risk has to be accepted. The chart shows a single company swinging much more than a broad fund, which holds many companies at once. If one company in a fund has a terrible year, the others soften the blow. Spreading money across many investments like this is called diversification.¹

Diversification can't remove the risk that the whole market falls, but it can greatly reduce the risk that one company's bad luck sinks your plan. It gets a full lesson in Part 5: Diversification.

Key takeaways

• Risk means uncertainty about results, including the chance of losing money.
• Price swings are temporary until you sell. Permanent losses are the risk that matters most.
• Higher potential return usually comes with a wider range of outcomes, including worse ones.
• An average return hides the path. Losses need larger gains to recover.
• Diversification reduces the risk of any single investment, but not the risk of the whole market.

Check your understanding

Fund A has a higher potential return than Fund B. What can you reasonably conclude?

1. Fund A will earn more than Fund B over the next five years, though not necessarily every year.
2. Fund A probably has a wider range of possible outcomes, including worse ones.
3. Fund A is a better investment than Fund B.

An investment falls 20%. How much does it need to gain to get back to where it started?

1. 25%
2. 20%
3. 15%

What's next

Time changes how risk and return play out. The next lesson, Compounding, shows how returns build on each other over the years, and why time is one of the most powerful things an investor has.