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Risk and return
Risk is the uncertainty that you may not earn your expected return on your investments. For example, you may expect to earn 20% on your stock mutual fund every year, but your actual rate of return may be much lower.
For example, the S&P 500 index averaged yearly gains of about 28% for the five years that ended in 1999. In 2000, however, the index declined more than 9% and in 2001 declined another 12%. Bonds, meanwhile, performed better than stocks for the first time since 1990. The S&P 500 index was back in the black in 2003 through 2005, averaging nearly a 15 annual return%.
The peril of investing in the stock market between 2000 and 2002 underscores the risk-return trade-off. The risk-return trade-off requires that you accept more risk in exchange for the chance to earn a higher rate of return. If unwilling, you should expect to earn a lower return. Conservative investors, for example, are less willing to lose 10% of their investments in exchange for the chance to earn a higher rate of return. Aggressive investors, on the other hand, are willing to accept this risk in exchange for the chance to earn higher returns.
Some investors argue that the late-1990s was a unique period where a unique set of factors drove stock market
indexes to record highs. The Internet allowed millions of individuals to buy and sell stocks and mutual funds for the first time.
Venture capital firms plowed billions of dollars into companies that went on to sell
shares in initial public offerings. In addition, American businesses spent billions of dollars on information technology. This combination of factors may have led investors to lose sight of the risk-return tradeoff.
The following table shows how the risk-return relationship has held over the long term. Annual rates of return are shown for stocks, bonds, and cash for the 50 years ended in 1996:
Annual rates of return,
1946 to 1996 |
Stocks |
Bonds |
Cash |
| Unadjusted for inflation |
12.1% |
5.8% |
4.8% |
| Adjusted for inflation |
7.8% |
1.5% |
0.5% |
Best annualized return
(5-year holding period) |
23.9% |
17.0% |
11.1% |
Worst annualized return
(5-year holding period) |
-2.4% |
1.0% |
0.8% |
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The table shows that, of the three major asset classes, stocks offered the greatest rates of return over the long term, but stocks were also the most volatile. Divided into holding periods of five years, stocks lost 2.4% in their worst period. Bonds and cash never lost money in any of the periods.
To some degree, you can reduce risk by hedging or diversifying your investments. However, the risk-return trade-off steers investors with little or no risk tolerance toward making smaller allocations to stocks than investors with a high degree of risk tolerance.
Major types of risk include:
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