Course outline
Lesson 9 of 206 min read
The risk–return tradeoff
Investments that can grow more also tend to swing more. Understanding that tradeoff is the heart of investing.
No free lunch
Investors expect to be paid for taking risk. Cash is steady but grows slowly. Bonds wobble a bit more and have earned more. Stocks swing the most and have earned the most over long periods.
| Asset | Typical ups and downs | Long-run growth potential |
|---|---|---|
| Cash / savings | Very small | Low; may only keep up with inflation |
| Bonds | Moderate | Moderate |
| Diversified stocks | Large; drops of 30–50% have happened | Highest of the three historically |
| Single stocks, crypto | Very large; can go to zero | Wide range, including total loss |
What risk actually feels like
Volatility is how much prices bounce around. In a typical year, a stock index might move 15–20% either way from its average. In rare years, much more: US stocks fell by roughly half during the 2008 financial crisis, and by about a third in a few weeks in early 2020.
The bigger risk for most people isn't a drop itself. It's selling in a panic during the drop and missing the recovery, which turns a temporary fall into a permanent loss.
Risk you can take versus risk you should take
Your risk capacity depends on your situation: how long until you need the money and whether you have an emergency fund. Your risk tolerance is how you'll actually feel and act when your balance drops.
Key takeaways
- Higher expected returns come with bigger swings.
- Selling during a drop can turn a temporary loss into a permanent one.
- Choose a level of risk your timeline and your nerves can both handle.
Key terms
- Risk tolerance
- How much ups and downs in your investments you can handle, financially and emotionally, without abandoning your plan.
- Volatility
- How much and how quickly an investment's price moves up and down.
Check your understanding
Quick quiz
0 of 3 answered