Understanding Risk & Return: What Every Investor Should Know

What Is Investing Risk?

Investing risk refers to the possibility that an investment's actual return will differ from its expected return. It's not just about losing money – it's about the uncertainty of outcomes. Think of risk like navigating a road trip – you can't avoid every bump, but you can prepare for the journey by understanding the terrain. This way, you can ultimately make informed decisions. Common types of investment risk include: 

What Are Investment Returns?

Investment returns are the profit or loss generated from an investment over a specific time frame. Returns are an important feedback loop to let you know how an investment is performing. They also provide a way to compare investments, especially when you’re looking to choose between different investment options. There are different types of returns, including:

• Capital gains, profit from selling from an investment at a higher price than its purchase price
• Dividend income, regular payments from companies to their shareholders (e.g., quarterly dividend payment from a stock)
• Interest income, earnings from lending money – like earning interest on a high-yield savings account or bond

Managing Investment Risk and Reward

As you may know, there's a fundamental relationship between risk and return – typically, the greater risk, the greater potential for a higher return.

While no one can avoid risk entirely, each investor has their own sweet spot of how much risk they may be willing to accept, or risk tolerance. Whether your risk tolerance is aggressive, conservative, or somewhere in between, it’s typically comprised of several factors — things like your time horizon for investing, financial goals, and comfort with market volatility.

These are factors that may change over time — in fact, it's quite normal for this to happen. For example, as some investors near retirement, they may become more risk averse since they have less time to make up any losses.

That said, investors can sometimes overestimate returns and underestimate risk or gain a false sense of confidence after a successful risky investment. Others may focus too much on total return instead of real return, ignoring the impact of inflation, fees, and taxes. On the other hand, some investors may become too conservative, missing out on potential growth. To manage risk effectively, especially as your appetite for risk may change over time, you can:

1. Define asset allocation for your portfolio and then rebalance periodically. Typically, portfolios contain different weightings of various asset classes – the weighting of investments is the asset allocation. For example, an investor may choose an allocation of 60% stocks and 40% bonds. Over time, those weightings can skew, based on the normal ups and downs of the market. Rebalancing is simply the act of buying/selling investments to get back to the investor’s defined weighting. It sounds complicated, but rest assured, it's something a financial professional or financial advisor can help you with.
2. Evaluate your risk tolerance using tools like the Risk Tolerance Quiz.
3. Consider benchmark comparisons to assess investment performance.
4. Work with a financial professional to create a personalized investment strategy. This may include diversifying, so that your portfolio contains a range of different asset classes (stocks, bonds, real estate, cash, etc.). That way, when one asset class may be performing weakly, it can be counterbalanced by other asset classes that are hopefully performing strongly.

Putting It All Together

Remember, risk is always going to be part of the equation when it comes to investing and the stock market — so it’s good to approach it knowing it’s something to be managed, not feared. By having a plan in place and understanding your risk tolerance, you can navigate risks with confidence. Strategies like having a diversified portfolio, rebalancing, and working with the right financial professional or financial advisor can help you work towards your financial goals.