What is Return?
Returns are how people make money on the market; they are the incentive to participate in the global economy. The hope of growing money drives everything from home loans to mutual funds. However, while some might think of returns as “free money,” there is always a risk of loss.“Return” is simply the change in value since the start of an investment. If a and sells for a profit, it has a positive return; if the asset sells for less than its purchase price, it has a negative return. Some returns do not involve actively trading assets. A savings account at a bank provides returns through its interest rates, while stocks and bonds can payout dividends without needing to be sold.
What is Risk?
Using the word “risk” to describe parts of the market can cause a misunderstanding of how things work. In common usage, the word “risk” describes a danger that someone voluntarily embraces. In terms of investment, risk has come to mean how much an asset’s value fluctuates over time.
A risky stock is one that is difficult to predict; no one knows if it will rise or fall. The riskier the stock appears the less people are willing to pay for it. As the price falls, investors are able to buy more shares of the risky stock. The more shares they own, the greater their gains and losses when the stock price moves. A high level of risk creates a high potential for return.
Different types of assets have different levels of risk and return. In general, stocks have the highest risk and return of all assets. Most bonds are considered safer than stocks, but have much lower returns. Not surprisingly, cash equivalents, which have very little risk, provide meager returns.
There is always some form of risk when investing money. Certain people try to avoid risk by putting their money into bank savings accounts or investing only in U.S. Treasury Bonds (considered a “riskless” asset). However, in both of these cases, people tend to lose money because inflation decreases value faster than marginal interest can make returns. Money put in the market may have some risk, but smart investing is preferable to the guaranteed loss of low-interest savings over a long period.