Risk and reward

Introduction

Every investment involves some degree of risk. Whether you invest in stocks, bonds, real estate, or other assets, there is always a possibility that the outcome will be different from what you expected. In return for accepting this uncertainty, investors expect the opportunity to earn a return on their money.

This relationship is known as risk and reward. Investments with relatively low risk generally offer lower potential returns, while investments with greater uncertainty may offer higher potential returns.

However, taking more risk does not automatically result in a higher return. A risky investment may perform exceptionally well, but it can also lose a significant part of its value. The potential for higher returns is compensation for accepting greater uncertainty, not a guarantee of better results.

Understanding this relationship is an important part of investing. It can help you compare investments, build a portfolio that matches your goals, and avoid taking risks you may not need or be prepared for.

What is investment risk?

Investment risk is the possibility that the actual outcome of an investment will differ from what you expected. Most people associate risk with losing money, but investment risk can take several forms.

An investment may decline in value, provide less income than expected, or produce a return that fails to keep up with inflation. Some investments also experience much larger price fluctuations than others.

For example, imagine buying a stock for $100. One year later, it could be worth $120, but it could also fall to $80. You do not know the outcome when you make the investment. That uncertainty is part of the risk you accept.

Different investments also expose investors to different risks. A government bond and an individual technology stock, for example, do not have the same likelihood or magnitude of potential losses.

Risk cannot be completely removed from investing. Instead, investors generally try to understand which risks they are taking and whether those risks are appropriate for their situation.

What is investment reward?

Reward refers to the return an investor receives from an investment. Returns can come from several sources depending on the asset.

A stock, for example, can increase in price. If you buy a share for $100 and later sell it for $120, you have made a $20 capital gain. Some stocks also distribute part of their profits to shareholders through dividends.

Bonds generally provide returns through interest payments, while other investments may generate rental income, distributions, or other forms of cash flow.

When multiple sources of return are combined, investors can look at the total return of an investment.

Suppose you buy a stock for $100. During the year, you receive $3 in dividends and the stock price increases to $107. Your total gain is $10, consisting of $7 in price appreciation and $3 in dividends. Your total return would therefore be 10%.

Returns can also be negative. If the investment loses more value than it generates in income, the investor experiences a negative total return.

How risk and reward are connected

Risk and reward are closely connected because investors generally require a greater potential return before accepting greater uncertainty. If two investments offered exactly the same expected return, but one carried much more risk, there would be little reason to choose the riskier one.

This is why safer investments usually offer more modest return potential. Investments with a greater chance of loss may need to offer the possibility of higher returns to attract investors.

The important word is potential. Higher risk may create the opportunity for a higher return, but it also increases the range of possible outcomes. The investment could perform very well, deliver an average result, or lose money.

For example, keeping money in a savings account generally involves much less uncertainty than buying shares in a young company. The savings account may offer a relatively predictable return, while the stock could rise substantially or fall sharply.

Good investing is therefore not about taking as much risk as possible. It is about taking risks that are reasonable for the return you hope to earn and the goal you are trying to reach.

Common types of investment risk

Investment risk does not come from a single source. Different assets can be affected by different events, and several types of risk may exist at the same time.

Market risk

Market risk is the possibility that an investment falls in value because financial markets decline. Economic recessions, changes in interest rates, geopolitical events, or shifts in investor sentiment can affect many investments at once.

Company-specific risk

Individual companies can face problems that have little to do with the broader market. Weak earnings, poor management decisions, new competition, lawsuits, or the loss of an important customer can all hurt a company’s share price.

Interest rate risk

Changes in interest rates can affect the value of many investments, particularly bonds. When market interest rates rise, existing bonds with lower rates may become less attractive, which can cause their market prices to fall.

Inflation risk

Inflation risk is the possibility that your investment return does not keep pace with rising prices. An investment can increase in dollar value while still losing purchasing power if inflation is higher than the return you earn.

Liquidity risk

Liquidity refers to how easily an investment can be bought or sold without significantly affecting its price. Some investments can be sold almost instantly, while others may take much longer to convert into cash.

Understanding these risks can make it easier to compare investments that may appear similar at first glance.

Risk does not mean volatility alone

Volatility describes how much the price of an investment moves up and down. A highly volatile investment may experience large price changes over short periods, while a less volatile investment tends to move more gradually.

Volatility is one form of risk, but it is not the only one. A temporary decline in price is different from a permanent loss of capital.

For example, a diversified stock portfolio may fall during a broad market downturn and later recover. An individual company that goes bankrupt, on the other hand, can cause investors to lose most or all of the money invested in that company.

This distinction matters because investors with long time horizons may be able to tolerate temporary market fluctuations more easily than investors who need their money soon.

How different investments compare

Different asset classes have different risk and return characteristics. The table below provides a simplified comparison. Actual risk can vary significantly within each category.

This does not mean every stock is riskier than every bond or that every speculative investment will generate a high return. Risk exists on a spectrum, and the characteristics of the specific investment still matter.

Your time horizon affects how much risk you can take

Your time horizon is the amount of time before you expect to need the money you are investing. It can have a major influence on how much investment risk is reasonable.

If you need the money next year, a large market decline could create a serious problem because you may have to sell before prices recover. For short-term goals, preserving capital is often more important than maximizing potential growth.

If your goal is decades away, short-term market fluctuations may matter less. A longer time horizon gives an investment more time to recover from downturns, although recovery is never guaranteed.

This is one reason money for an emergency fund or an upcoming purchase is generally treated differently from money intended for retirement many years in the future. Our guide to investing vs saving explains this distinction in more detail.

Risk tolerance vs risk capacity

Two investors can have the same financial goal and still be comfortable with very different levels of risk. A useful way to think about this is to separate risk tolerance from risk capacity.

Risk tolerance describes how comfortable you are with uncertainty and temporary losses. Some investors can watch their portfolio fall sharply without changing their strategy. Others may feel uncomfortable with much smaller declines.

Risk capacity describes how much financial risk you can realistically afford to take. It depends on factors such as your time horizon, financial obligations, income stability, and when you expect to need the money.

You might have a high tolerance for risk but a low capacity for it. For example, you may feel comfortable owning volatile investments, but if you need the money for a home purchase in six months, you have little room to absorb a major loss.

A sensible investment approach considers both. Taking more risk than you can financially or emotionally handle can make it difficult to stay invested when markets become volatile.

How diversification can reduce risk

One of the most common ways investors manage risk is through diversification. Diversification means spreading your money across multiple investments instead of relying heavily on a single company, sector, or asset.

Imagine investing your entire portfolio in one company. If that business performs poorly, your whole portfolio could suffer. If the same money is spread across many companies, the problems of one business may have a much smaller effect on the total portfolio.

Diversification can also involve holding different asset classes, such as stocks and bonds, because they may respond differently to economic conditions.

Diversification does not eliminate risk and cannot guarantee against losses. It mainly reduces the impact that any single investment can have on your overall portfolio.

Taking more risk is not always better

A common mistake is assuming that the highest-risk investment must also be the best opportunity. That is not how the risk and reward relationship works.

Some risks are worth taking because they provide reasonable return potential. Other risks may offer little additional benefit or depend heavily on speculation.

Consider two investments with similar expected return potential. If one is broadly diversified and the other depends entirely on the success of a single company, the second investment may expose you to more risk without offering enough additional reward to justify it.

This is why investors often focus on the return they may receive relative to the risk they are taking, rather than simply searching for the investment with the highest possible upside.

Finding the right balance

There is no single level of risk that is appropriate for every investor. The right balance depends on what the money is for, when you will need it, and how much uncertainty you can reasonably accept.

Someone investing for retirement several decades away may be willing to accept significant short-term fluctuations in exchange for greater long-term growth potential. Someone saving for a house they plan to buy next year may place much more value on stability.

The goal is not to remove all risk. Avoiding investment risk completely can introduce other risks, including the possibility that inflation gradually reduces the purchasing power of your money.

Instead, the objective is to understand the risks you are taking and make sure they serve a purpose within your overall financial plan. If you are still learning how investments fit into that plan, start with our guide to what investing is and how it works.

Key takeaways

• Every investment involves some form of risk.
• Higher risk can come with higher potential returns, but higher returns are never guaranteed.
• Investment risk includes more than price volatility. Inflation, interest rates, company-specific problems, and liquidity can also affect outcomes.
• Your time horizon, risk tolerance, and risk capacity all influence how much risk may be appropriate.
• Diversification can reduce the impact of individual investments, but it cannot eliminate risk.
• Good investing is not about maximizing risk. It is about taking an appropriate amount of risk for the return you are trying to earn.