Risk and return: an introduction

Risk is a complex topic. There are many types of risk, and many ways to evaluate and measure risk. However, when it comes to investing, risk can be summarized simply as follows: “Risk is the uncertainty that an investment will earn its expected rate of return.”

Asset classes, risk, and return
There is very high certainty in the return that will be earned on an investment in a 30-day Treasury bill (T-Bill) or short-term certificate of deposit (CD). Similarly, there is fairly high certainty of the return that will be earned over a short period in a money market fund. These types of investments are referred to collectively as money market securities. For an individual investor, a federally-insured bank account also provides a high degree of certainty in the short-term return.

The return on a bond fund is less certain, and the return on a stock fund is even more uncertain. Thus, the bond fund is considered riskier than money market securities, and the stock fund is considered riskier than the bond fund.

Investors are risk averse. Therefore they demand a higher expected return for riskier assets. Note that a higher expected return does not guarantee a higher realized return. In other words, risk is real--the investor may not achieve the expected return.

If inflation is considered, even money market investments have some risk, in that they may not achieve the expected real return (inflation-adjusted return). Unexpected inflation may reduce the real return below the expected return of the money market investment.



Definitions of risks
Below are definitions of different types of investment risks, in alphabetical order.

Stock market risks
main article: Stock Basics


 * Business Risk--the measure of risk associated with a particular security. It is also known as unsystematic risk and refers to the risk associated with a specific issuer of a security. A common way to avoid unsystematic risk is to diversify - that is, to buy mutual funds, which hold the securities of many different companies.
 * Financial Risk--the risk due to the capital structure of a firm. Corporate debt magnifies financial risk.
 * Liquidity Risk--the risk that an asset cannot be sold when desired due to a thin market.
 * Market Risk--the systematic risk faced by all equity investors due to market volatility. This risk can not be diversified away. This is the type of risk most people are referring to when they casually use the term "risk" with respect to investments, without qualification.
 * Political Risk--the risk to an investment due to changes in the law or political regime. Potential changes in tax law or changes in a country's structure of governance are sources of political risk.

International stock market risks
''main article: Domestic/International


 * Business Risk--the measure of risk associated with a particular security. It is also known as unsystematic risk and refers to the risk associated with a specific issuer of a security. A common way to avoid unsystematic risk is to diversify - that is, to buy mutual funds, which hold the securities of many different companies.
 * Currency Risk--the risk due to changes in exchange rate. Investments in currencies other than the one in which you purchase most goods and services are subject to currency risk.
 * Financial Risk--the risk due to the capital structure of a firm. Corporate debt magnifies financial risk.
 * Liquidity Risk--the risk that an asset cannot be sold when desired due to a thin market.
 * Market Risk--the systematic risk faced by all equity investors due to market volatility. This risk can not be diversified away. This is the type of risk most people are referring to when they casually use the term "risk" with respect to investments, without qualification.
 * Political Risk--the risk to an investment due to changes in the law or political regime. Potential changes in tax law or changes in a country's structure of governance are sources of political risk.

Fixed income market risks
main article: Bond Basics


 * Business Risk--the measure of risk associated with a particular security. It is also known as unsystematic risk and refers to the risk associated with a specific issuer of a security. A common way to avoid unsystematic risk is to diversify - that is, to buy mutual funds, which hold the securities of many different companies.
 * Call Risk--the risk that a bond issuer, after a decline in interest rates, may redeem a bond early, forcing the bond holder to find a replacement investment that may not pay as well as the original bond.
 * Credit Risk--the risk of default. Holders of bonds face this risk.
 * Financial Risk--the risk due to the capital structure of a firm. Corporate debt magnifies financial risk.
 * Inflation Risk--the risk that one's investment will not keep pace with inflation. This risk can be mitigated by investing in inflation protected Treasury bonds or other assets thought to rise with inflation.
 * Interest Rate Risk--the risk associated with changes in asset price due to changes in interest rate. Bonds and bond funds face this type of risk. As interest rates rise, prices on existing bonds decline and vice versa.
 * Liquidity Risk--the risk that an asset cannot be sold when desired due to a thin market.
 * Market Risk--the systematic risk faced by bond investors due to market volatility. This risk can not be diversified away. This is the type of risk most people are referring to when they casually use the term "risk" with respect to investments, without qualification.
 * Political Risk--the risk to an investment due to changes in the law or political regime. Potential changes in tax law or changes in a country's structure of governance are sources of political risk.
 * Reinvestment Risk--the risk that earnings from current investments will not be reinvested at the same rate of return as current investment yields. Coupon payments from a bond may suffer reinvestment risk if they cannot be reinvested at the same rate as the bond's yield.

Investment management risk

 * Management Risk--the risk that fund or portfolio managers will under-perform benchmarks due to their management decisions or style. Active funds face this risk. Investors can avoid this risk by selecting index funds.

Life risks

 * Longevity Risk--the risk you will outlive your money.
 * Under-performance Risk--the risk your portfolio will not provide sufficient returns to meet your goal(s). Stuffing your cash under your mattress is associated with this type of risk.

Asset Allocation
main article: Asset Allocation

Selecting the appropriate asset allocation (stock to bond ratio) is essential to setting up your portfolio. To minimize risk, you should hold a certain percentage of your portfolio in bonds. If you are unsure of where to start, or would like a comparison with the Bogleheads' recommendations, the Vanguard Investor Questionnaire can assist you in choosing the appropriate asset allocation for your situation.

Caveat: The questionnaire does not take your entire situation into account. Use it as an approximation and proceed from there.