Risk vs Return Explained for Beginner Investors

 Turning point for any new investor is to understand the risk and return. 

I've seen many new investors think that, there are no consequences to getting higher returns. Some individuals have view, that all investments make a return and others don't invest at all, Because they're frightened of losing money. Both methods typically stem from a misunderstanding of how risk and return are related.

In my last blog “Investing Basics Explained for Beginners”, I have already written that investing is not just about making money. It's also about grasping uncertainty, time and monetary targets. The concept of risk vs return is at the heart of that concept.

One advantage of saving in a bank account is that the amount of money that you have in there doesn't change all that much. But a stock or ETF investor could experience wider price swings. These are two scenarios and the difference is the concept of risk and return in the investor's mind.

The idea is relevant regardless of the amount invested (whether it be $100 or retirement planning in the US or Europe). Knowing it can be useful in not setting up unrealistic expectations or making emotional decisions.

Table of Contents

• What Does Risk Mean in Investing?
• What Does Return Mean in Investing?
• Why Risk and Return Are Connected
• Basic Example of Risk vs Return
• Types of Investment Risk
• Is there any benefit to lower risk investments?
• How Time Changes Investment Risk
• Risk Tolerance Matters More Than Trends
• Diversification and Risk Reduction
• Is High Risk Always Better?
• Final Thoughts
• Frequently Asked Questions (FAQ)

What Does Risk Mean in Investing?

Risk is the chance that a particular investment might not deliver the results that are anticipated.

This may mean that the investor can lose some of their capital, make less profit than anticipated, or have significant short- or long-term price variations. There are a variety of degrees of uncertainty to different investments. 

For instance, the value of a savings account generally is relatively low risk. A stock market investment can gallop rapidly, and it can plummet at times of economic downturn. 

Many new investors associate the word risk with losing money on a permanent basis. But in fact, the risk can be just a volatility, loss of purchasing power due to inflation or failure to achieve long-term financial objectives.

What Does Return Mean in Investing?

Return is the benefit or detriment of an investment over periods of time. 

If someone invests $1,000 and the investment grows to $1,100, the return is $100 or 10%. They can be returns on price, dividend, interest, or other income. 

The potential returns tend to be greater the more uncertain outcomes are. The relationship is the basis of investing. 

In addition, I explained a similar idea in my post “SIP vs Lump Sum Investment Explained”, where I discussed how the timing and the market movement can affect the long term investment.

Why Risk and Return Are Connected

Investments with a higher potential return will come with more uncertainty. 

For instance, returns on government bonds are more predictable and are considered to be lower risk. Stocks can experience more volatile short-term price movements, but have more solid long-term growth potential. 

This relationship arises because about the additional uncertainty that investors are willing to take in exchange for the added compensation. Any investment that guarantees exceptional profits without risk should be examined for careful investment. 

However, it is not always a good idea to invest in high-risk investments. It just means that there will be more volatility of value associated with a bigger potential reward.

Basic Example of Risk vs Return

Suppose that two people invest $10,000. 

One person deposits his money in a savings account that yields 3% per year. A gradual increase in the account, but no changes to the balance.

Another person buys a stock market index fund. The investment can increase by 15% in one year, and decrease by 10% in the next. The longer-term average return may be larger, but the return may be more erratic.

The first option focuses more on stability. The second accepts more uncertainty for the possibility of stronger long-term growth.

Types of Investment Risk

Market risk occurs when prices change due to economic factors, inflation, interest rates, and other global conditions. 

Inflation risk arises when investment income doesn't reach the level of living expenses. Safe savings can actually lose purchasing power over time. 

Liquidity risk is there when an investment cannot be sold at a moment's notice without causing a price change. 

With bonds and fixed-income investments, interest rate risk can often be a factor. As interest rates are increasing, the value of bonds that are currently in market will decline. 

Emotional risk exists as well. During a downturn, many investors begin to panic and sell prematurely. The behavior can hurt the long-term performance more than the market.

Is There Any Benefit to Lower Risk Investments?

Yes, this is where many people who start out get confused. 

Individuals might want to invest in lower-risk options to help maintain emergency savings, execute short-term investment plans, or minimize the total risk of their portfolios. Not all dollars should be aggressive. 

In my previous article, "What Is an Emergency Fund and Why You Need One", I mentioned how it is important to consider safety and easy access as the primary components of an emergency fund and not high returns. 

The optimal ratio will vary based on financial objectives, holding period, and tolerance for volatility.

How Time Changes Risk

One of the most important factors in investing risk is TIME. 

The markets can be volatile, making short term investing more unpredictable. The occasional drop may be less of a problem for long-term investing. 

For instance, investments in the stock market may go up and down significantly in a couple of months. Historical evidence over many decades has illustrated a variety of recovery and growth themes in markets in a general sense. 

That's one reason why retirement investors tend to concentrate on the longer time frame rather than on day-to-day price movements.

Risk Tolerance Matters More Than Trends

Two investors may invest the same amount, and select two completely different strategies. 

One investor might want a steady increase in assets and less fluctuation. Another one might be willing to take bigger swings on the market for the promise of greater returns. 

Risk tolerance relies on the steady income, economic objectives, debts, age, and psychological comfort.

In “Financial Mistakes Beginners Make”, I mentioned this attitude, and how it can leave long-term financial issues. 

It is easy to get carried away and panic when markets are down by following trends without knowing your tolerance for risk.

Diversification and Risk Reduction

Diversification is spreading the investment between various asset classes rather than sticking to a single investment. 

If the investor holds only one stock in a particular company, they could be at a greater concentration risk. A diversified portfolio can include stocks, ETFs, bonds and cash-based assets. 

Diversification does not eliminate risk, but it can minimize the risk from a poor performing investment.

This idea connects closely with my earlier comparison article “ETF vs Mutual Fund: Key Differences”, where I explained how pooled investment products help spread exposure across multiple assets.

When Is the High-Risk Option the Better Choice?

Not necessarily. 

Others think that risk and reward are directly proportional. It is not like real investing. There are also some investments that are deemed high-risk, and they can yield disappointing results. 

When it comes to good investing, it's typically all about balance, consistency and knowing what your goals are. 

An investment plan should be based on actual economics, rather than online fads or social media hypes.

Final Thoughts

Risk and return go hand in hand in all investment options. 

Lower-risk investments will provide more stability with less growth. Riskier investments can offer more potential growth over time, but can also have more volatility. 

The knowledge of this balance will help investors make rational investment decisions and prevent unrealistic expectations. It also provides a more solid long-term financial planning basis. 

Risk is never fully eliminated when investing. It is about knowing the amount of uncertainty that can be included in your objectives, schedule and level of comfort.

Frequently Asked Questions (FAQ)

1. What is the difference between risk and return?

Risk is the chance of losing money or facing market fluctuations, while return is the profit or growth earned from an investment. Higher potential returns usually come with higher levels of risk.

2. Is there a relationship between risk and return?

Yes, risk and return are closely connected in investing. Investments with higher return potential often carry greater uncertainty and price volatility over time.

3. What is an example of risk and return?

A savings account offers lower risk and stable but smaller returns. Stock market investments may provide higher long-term returns, but prices can rise and fall frequently.

4. What are the 4 types of risk in investing?

Common investment risks include market risk, inflation risk, liquidity risk, and interest rate risk. Each can affect investment value differently depending on market conditions.

5. What is risk and return for beginners?

Risk means the possibility that an investment may not perform as expected. Return refers to the money earned or lost from that investment over a certain period.

6. What is the 15 × 15 × 30 rule?

The 15 × 15 × 30 rule is a common investing example showing how investing regularly over a long period may grow through compounding. It is often used to explain long-term investing concepts simply.