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.”

Uncertainty of returns as risk


The uncertainty inherent in investing is evidenced in the historical distribution of returns of the three major U.S. investment asset classes: cash investments, bond investments, and stock investments.

T-Bills and CDs are among the investments 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 term cash often is used to refer to money market securities and money in bank accounts. Vanguard refers to these types of assets as short-term reserves.

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 in the return that will be earned over a short period in a money market fund.

Even over longer time periods, the returns earned by T-Bills, CDs and money market funds fall into a relatively narrow range.

As seen in the top chart in Figure 1 (covering the years 1928 through 2011), the tallest bar shows that annual returns (horizontal axis) on 3-month T-Bills have fallen in the range of 0% to 5% in 59 years (vertical axis). Returns have been between 0% and 10% in most years (tallest two bars), and between 0% and 15% in all years (all three bars).

The return on bonds is less certain, and the return on stocks is even more uncertain. Thus, bonds are considered riskier than money market securities (cash), and stocks are considered riskier than bonds.

The middle chart in Figure 1 shows the range of annual returns on 10-Year Treasury Bonds from 1928 through 2011. Note the larger range (dispersion) of returns--from about -11% to +33%.

The bottom chart in Figure 1 shows the range of annual returns on stocks in the S&P 500 from 1928 through 2011. Note the much larger dispersion of returns--from about -44% to +53%.

Relationship between risk and return
Investors are risk averse; i.e., given the same expected return, they will choose the investment for which that return is more certain. Therefore, investors demand a higher expected return for riskier assets. Note that a higher expected return does not guarantee a higher realized return. Because by definition returns on risky assets are uncertain, an investment may not earn its expected return.

Although the charts in Figure 1 show historical (realized) returns rather than expected (future) returns, they are useful to demonstrate the relationship between risk and return. Note that the mean (average) annual return increases as the dispersion of returns increases.

This demonstrates one of the most fundamental axioms of investing: ''Risk and return are inextricably related. Higher returns generally can be achieved only by taking more risk, but because the risk exists, the higher expected returns may not result in higher realized returns.''

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

Uncertainty in real returns can be eliminated by investing in inflation-indexed securities, such as Treasury Inflation Protected Securities (TIPS) and Series I Savings Bonds (I Bonds). Of course in return for this reduction in uncertainty, investors must accept lower expected returns.

Shortfall risk
One of the most significant risks investors face is shortfall risk—the possibility that a portfolio’s value will be insufficient to finance the targeted goal.

Diversifying risk
The risk of investing in a single stock or a single corporate or municipal bond is very high, since any number of unfortunate events could result, in the worst possible case, in an investor losing all of the investment (financial theorists call this risk "unsystematic" or "specific" risk). These risks can be mitigated by holding a diversified portfolio of many different stocks in many different industries (such as holding a total market index fund) or a portfolio of many different bond issuers (such as a total bond index fund, or a diversified tax-exempt bond fund).

Diversification leaves an investor exposed to market risk, the fluctuations of the overall market. Financial theorists call this risk "systematic" risk.

Asset allocation sets your level of risk
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.

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


 * 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.


 * 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.


 * 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.


 * Longevity Risk--the risk you will outlive your money.


 * 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.


 * 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.


 * 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.


 * 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.