The Relationship of Risk to Reward

Stocks, bonds, or cash — each of these investments performs very differently. Stocks go up and down more dramatically than bonds or cash and bonds more so than cash. When these investments go down you lose money, when they go up you gain money. That is what is meant when investors talk about risk. Risk is the chance that you will lose or gain money on an investment. Since stocks go up and down more than bonds or cash, stocks are a riskier investment. What is important to understand is that over the long term riskier investments generally earn more than less risky investments, stocks more than bonds, bonds more than cash. Therefore there is a relationship between risk and reward.

The graph below shows the growth of $1 invested in stocks, bonds, and cash on January 1, 1988. Notice how the different investments performed differently. You will see on the graph that, while stocks fluctuated up and down more than bonds or cash, stocks often outperformed bonds and always outperformed cash. The same was true of bonds when compared to cash.

Again looking at the chart notice the gain for stocks over the long term. Look more closely. Notice the dramatic ups and downs of stocks. That is what we call risk. The more dramatic the ups and downs the riskier the investment type. Investors react differently depending on the amount of risk. We tend to sell when investments go down sharply, when we lose money. Selling when we are losing money means that we miss the next up swing. We sell low. This behavior means that we lose the benefits of the riskier investment.

The key to successful investing is to understand this relationship between risk and reward and select a portfolio that fluctuates no more than you are comfortable with. By selecting the right portfolio you invest in a way that allows you to benefit fully from investing.

The next step is to discover how much risk you can tolerate.

• Take our Risk Tolerance Questionnaire