In personal finance, you’ll see these two terms being thrown around a lot - risk and return. Today, we’ll take a deeper dive into what they mean.
Loosely, return is the money you make on an investment. Risk is the possibility of loss. This is the definition many people run with, but the picture is incomplete.
Strictly, return is the money gained or lost on an investment in a period of time. Rate of return is return, annualized. Risk is the variability of return.
This definition helps understand why risk and return are correlated. All other things equal, the possibility of greater returns only comes with greater risk.
Why should this be the case? Let’s take two investments
Investment A is risk-free - say a government security. You cannot lose money in it unless your government defaults. Its face value is 100. Coupon rate is 5%.
Investment B is risky - a bond issued by a start-up. Its face value is 100. Coupon rate is 5%.
Which one would you invest in? A, of course.
What would company B need to do for people to buy its bonds? Increase the coupon rate! Maybe 8 or 10% might be a good rate depending on its creditworthiness.
This same principle applies to any investment. For a stock, you can calculate risk by looking at its historical data. For real estate, you can use the market statistics for your type of unit and location.
The lesson here is that if you see an instrument that promises high returns, it comes with greater risk, one way or the other. If it’s kosher(say a small cap stock), then the risk comes intrinsically (market risk in this instance). For something ill-understood or poorly regulated(crypto as an example), the risk can be operational(fraud on one end, changes to regulation on another).
A corollary to this lesson is that if you have two instruments that have the same historical return, you should pick the one with lower risk. This is an important measure when comparing stocks or mutual funds. Formally, this measure is the Sharpe Ratio