Risk & Return

Risk, in a financial sense, is the uncertainty about whether an investment's actual outcome will match what you expected — including the chance you could lose some or all of what you put in.

Return is what you gain, or lose, from an investment, usually expressed as a percentage of what you originally put in.

The risk-return relationship is the observation that riskier investments have to offer a higher expected return than safer ones, on average — otherwise no one would choose to take on the extra risk instead of a safer option.

If a risky investment and a safe investment offered the exact same expected return, every rational investor would choose the safe one — there'd be nothing to gain from taking on the extra uncertainty, and something to lose. For anyone to willingly accept added risk, the riskier option has to promise something extra in return. If it didn't, money would drain out of risky investments and into safe ones until, per supply and demand, the risky option was forced to offer a higher return to attract anyone back, or the safe option's return got bid down by everyone piling into it.

This is the same idea behind What an Interest Rate Fundamentally Is: part of any rate of return is compensation for risk — a risk premium— layered on top of a baseline return for giving up the money's use and for expected inflation. A government bond from a stable country carries very low risk of not being repaid, so it can offer a low return and still attract lenders. A new small business borrowing money, or a young company's stock, carries a much higher risk of loss, so it has to promise a higher expected return to attract anyone willing to put money in.

"Expected" is the key qualifier — risk and return describe averages and probabilities, not guarantees. A risky investment offers a higher expected return precisely because its actual outcome is uncertain: it might do far better than a safe investment, or it might do far worse, including losing money outright. If a "risky" investment could only ever turn out better than a safe one, it wouldn't actually be risky.

Compare a government bond paying a steady 3%a year with very low default risk, against a small company's stock that has historically averaged 10% a year but has had individual years where it lost 30% or more.

$10,000 in the bond after 1 year:
  Reliably about $10,300 in almost every scenario.

$10,000 in the stock after 1 year:
  Could be $11,000 in a good year, or $7,000 in a bad year —
  the average across many years lands near 10%, but any single
  year varies widely.

This is why the bond suits money you can't afford to lose — a bill due next month — while the stock suits money that can withstand swings over a much longer time horizon, the same horizon that makes compounding add up over time.