Risk and Return

Overview

Risk and return describe two sides of an investment outcome: what an investor might gain and what could differ from that hoped-for result. Comparing them helps explain why a promised return cannot be judged without considering how uncertain it is.

Returns can be measured after the fact or estimated before an investment is made. Risk cannot be reduced to one number in every situation because losses can arise from different sources and matter differently across time horizons.

Return includes income and changes in value

An investment can generate return in two main ways: ^[1]

• Income, such as interest or dividends.
• A change in value, which creates a capital gain when the price rises or a capital loss when it falls.

To calculate a simple holding-period return, compare the investment's total gain or loss with its initial value:

$$R=\frac{V_1-V_0+I}{V_0}$$

Suppose an investment begins at $1,000, ends the year at $1,060, and pays $20 of income. Its total gain is $80, so its holding-period return is 8%:

$$\frac{1060-1000+20}{1000}=0.08$$

This simplified calculation assumes the income is received at the end of the period and ignores fees, taxes, additional contributions, and withdrawals. When cash flows occur during the period, more specialized methods may be needed to separate investment performance from the timing of money moving in or out.

Realized return and expected return answer different questions

The 8% in the example is a realized return: it describes what happened. Before the period begins, the ending price and income may be uncertain, so an investor can only estimate an expected return based on possible outcomes and assumptions.

For example, suppose an investment has a 50% assumed chance of returning 20% and a 50% assumed chance of losing 10%. Its probability-weighted expected return is 5%: half of 20% plus half of −10%. Neither outcome equals 5%, so the expected return is not necessarily the return an investor will experience.

Expected returns depend on the model, data, and assumptions used. A precise-looking estimate can still be unreliable when those inputs are incomplete or when future conditions differ from the past.

Risk is more than price volatility

Volatility measures how widely returns fluctuate. It is useful because returns that vary more widely are less predictable, but volatility treats upward and downward movements alike and says little about why a loss might occur.

Other material forms of risk include:

• Market risk: broad market movements can reduce an investment's value.
• Business or issuer risk: a company or other issuer may perform poorly or fail.
• Credit risk: a borrower may not make promised interest or principal payments.
• Liquidity risk: an asset may be difficult to sell quickly without accepting a lower price.
• Inflation risk: a positive nominal return may still fail to preserve purchasing power.
• Concentration risk: too much exposure to one issuer, industry, market, or risk factor can make a portfolio vulnerable to a single adverse event.

The relevant risk therefore depends on the investment and the investor's time horizon. A temporary price decline may be tolerable when money will not be needed for years, but the same decline can create a serious shortfall when the investment must be sold soon.

Why greater potential return usually comes with greater risk

Investors generally require compensation for bearing uncertainty and the possibility of loss. An asset seen as riskier must therefore offer a more attractive expected return to compete for capital. The additional expected return over a lower-risk alternative is often called a risk premium.^[2]

This relationship describes a required or potential return, not a guaranteed result. If a risky investment always delivered the higher return, it would not be risky in the same sense. Its actual return may be higher, lower, or negative.

Some risks may also go uncompensated. Owning one company's shares adds company-specific uncertainty, but investors may be able to reduce that concentration through diversification. The market does not necessarily offer a higher expected return for every avoidable risk an investor chooses to bear.

Comparing risk and return consistently

A useful comparison begins by putting the figures on a consistent basis:

1. Use the same time period. A one-month return and a one-year return are not directly comparable.
2. Use total return. Include relevant income as well as price changes.
3. Separate nominal from real return. Nominal return measures the change in money value; real return adjusts for inflation and better reflects changes in purchasing power.
4. Account for costs consistently. Gross returns before fees and net returns after fees answer different questions. Taxes may also affect an investor's result and vary by jurisdiction and circumstances.
5. Examine the source of risk. Two investments with similar volatility may have different liquidity, credit, concentration, or loss risks.

Historical returns and volatility can describe what occurred under past conditions. They do not establish what an investment will return or how risky it will be in the future.

Diversification changes some risks, not the basic trade-off

Combining investments whose outcomes do not move together can reduce the effect of a single holding on a portfolio. This can reduce company-specific or concentration risk without necessarily reducing expected return by the same amount.

Diversification does not eliminate every risk. A broad market decline, inflation shock, or widespread liquidity problem can affect many holdings at once. The risk-and-return decision therefore applies to the portfolio as a whole, not only to each investment considered separately.

Frequently Asked Questions