Risk and Return – Understanding Investment Trade-Offs

In investing, risk and return are inseparable. Higher potential returns usually come with higher uncertainty and larger ups and downs. Understanding this trade-off is at the heart of building a portfolio you can stick with over time.

This guide explains risk and return in practical terms: types of investment risk, how volatility and drawdowns work, why diversification matters and how to align your portfolio with your real-world ability and willingness to handle risk. For a broader context, see Investing 101 and Retirement Investing Basics.

What do “risk” and “return” really mean?

In everyday language, risk often means “danger.” In investing, risk is mainly about uncertainty:

• How much the value of an investment can move up or down.
• How likely you are to experience losses, especially over shorter periods.
• Whether you might fail to reach your financial goals.

Return is the reward you hope to earn for taking that risk: the growth of your investment over time, including price changes and income (such as interest or dividends).

The basic trade-off: no free lunch

Over long periods, investments with higher average returns, such as stocks, have historically shown larger short-term fluctuations than more stable assets like bonds or cash. This is the core risk-return trade-off:

• Low risk, low expected return: cash, high-quality short-term instruments.
• Moderate risk, moderate expected return: diversified bond funds.
• Higher risk, higher expected return: diversified stock funds and equity-heavy portfolios.
• Very high risk, potentially very high or very low return: concentrated stock bets, leverage, derivatives, speculative strategies such as aggressive day trading or leveraged forex.

There are no guarantees, but historically investors have been compensated for tolerating more risk with higher average returns over long time horizons.

Types of investment risk

Risk comes in many forms. Key types include:

• Market risk: the risk that broad markets fall, pulling many investments down at once.
• Company-specific or issuer risk: the risk that a single stock or bond performs poorly or defaults.
• Inflation risk: the risk that rising prices erode your purchasing power if your investments do not keep up.
• Interest-rate risk: the risk that rising rates cause bond prices to fall.
• Currency risk: changes in exchange rates affecting international holdings.
• Liquidity risk: the risk that you cannot buy or sell an investment quickly at a fair price.
• Behavioural risk: the risk of making poor decisions (for example, selling in a panic) due to emotions.

A core goal of portfolio construction is deciding which risks you are willing to take and which to minimize or avoid.

Volatility, drawdowns and sequence of returns

Three practical concepts help turn “risk” into something more concrete:

• Volatility: how much an investment’s returns vary over time. Higher volatility means bigger swings.
• Drawdown: the peak-to-trough decline from a high point to a subsequent low.
• Sequence of returns: the order in which gains and losses occur.

For someone who is still saving and adding money, volatility can be uncomfortable but is often tolerable. For someone withdrawing money in retirement, large early drawdowns combined with withdrawals can be especially damaging – this is called sequence-of-returns risk.

Our Retirement Investing Basics guide discusses how to plan withdrawals with these risks in mind.

Diversification: not putting all your eggs in one basket

Diversification is one of the most important tools for managing risk. It means spreading your investments across different:

• Asset classes (stocks, bonds, cash and possibly others).
• Regions (domestic and international markets).
• Sectors and industries.
• Individual securities.

Diversification can:

• Reduce the impact of any single investment performing poorly.
• Smooth returns if different assets do not all move together.
• Help limit the size of portfolio drawdowns compared with concentrated bets.

Tools like broad mutual funds and ETFs make diversification easier, especially for smaller accounts.

Risk tolerance and time horizon

Two personal factors play a big role in choosing an appropriate level of risk:

• Risk tolerance: your emotional comfort with seeing your investments go up and down. If you lose sleep over normal market volatility, a very aggressive portfolio may not be suitable.
• Risk capacity: your financial ability to take risk, based on your income, savings, obligations and time horizon.

In general:

• Longer time horizons allow for more exposure to volatile assets like stocks.
• Shorter time horizons usually call for more conservative allocations.
• If you know you will need money soon, it may not belong in high-risk investments.

Our Investing 101 guide discusses how to match asset allocation to time horizons in more detail.

Risk and different types of investments

Understanding risk and return can help you compare investment types:

• Cash and short-term instruments: low volatility and low expected returns, but inflation risk if returns do not keep pace with rising prices.
• Bonds: generally less volatile than stocks, with regular interest payments, but subject to interest-rate and credit risk. See Bonds Basics.
• Stocks: higher expected long-term returns, but larger short-term fluctuations and company-specific risks. See What Are Stocks?.
• ETFs and mutual funds: pooled vehicles that can reduce company-specific risk through diversification, but still carry market risk.
• Derivatives and leveraged strategies (options, futures, leveraged forex): can amplify gains and losses, often suitable only for experienced traders who fully understand the potential outcomes. See Options, Futures and Forex.

Risk management in practice

Practical ways to manage risk include:

• Setting an asset allocation: choosing a mix of stocks, bonds and cash aligned with your goals and risk profile.
• Diversifying within asset classes: using broad funds rather than concentrating in a few names.
• Rebalancing: periodically adjusting back to your target allocation so risk does not drift over time.
• Limiting speculative positions: keeping high-risk strategies to a small, clearly defined portion of your overall portfolio, if you use them at all.

Risk management is not about avoiding all risk, but about taking appropriate risks in a deliberate way.

Common mistakes in thinking about risk and return

Investors often run into trouble when they:

• Focus only on recent returns and ignore the risk taken to achieve them.
• Assume past performance guarantees future results.
• Take more risk than they can emotionally handle, then sell at the worst possible time.
• Forget about inflation risk and stay in cash for long periods.
• Use leverage or complex products without fully understanding the downside.

Aligning expectations with the reality of risk and return helps reduce the temptation to react emotionally during market swings.

Putting it together: building a risk-aware portfolio

A risk-aware portfolio:

• Starts with your goals, time horizons and financial situation.
• Uses an asset allocation that matches your ability and willingness to take risk.
• Relies on diversification and rebalancing, not prediction, as core tools.
• Treats high-risk strategies, if used at all, as speculative side bets, not the foundation.

For a step-by-step introduction to building such a plan, see Investing 101 and Retirement Investing Basics.

Risk and Return FAQ

For a broader introduction, see Investing 101. To learn how risk and return play out across different products, read What Are Stocks?, Bonds, Mutual Funds and ETF Basics. For the more speculative end of the spectrum, our guides to Day Trading, Forex, Options and Futures explain why these often carry much higher risk. For quick definitions, visit our Dictionary Index.