Increased Return for Risk Taken

Return is the amount that your investment provides at the end of a given period of time. For example, if you invest $100 and at the end of the year your investment is worth $110, your return is $10, or 10%.

Risk refers to the extent to which an investment may vary in value over a given period of time. For example, consider the following possible company stocks:

Both stocks have an average price over the week of $100. However, the stock price of Company 1 varies from a low of $50 to a high of $150. If a person went to sell that stock on a given day, she could receive a very high price ($150) or a very low price ($50) - it depends on the day of the week.

Thus, holding the stock of Company 1 implies a relatively high degree of uncertainty about the value of the stock on a given day. On the other hand, the stock of Company 2 has less variation in the price by day, with a low of $95 and a high of $105. The owner of that stock would have relatively less uncertainty about the price of the stock on a given day of the week.

We could say that the stock of Company 1 involves more “risk” than the stock of Company 2.

The Roles of Risk and Return in Investment

​Now that we've defined the terms, let’s consider the roles of risk and return in investing. People invest because they expect to achieve a positive return. But all investment involves some degree of risk - investors are paid, in part, for their willingness to take on risk. In many cases, higher returns are in fact associated with a higher degree of risk. However, since risk involves uncertainty, investors generally look to reduce the degree of risk to the extent possible for a given return.

This idea underlies what we call the return-to-risk ratios or the number we get when dividing return by risk for a given period of time. A higher ratio means a better return for the degree of risk taken.