Understanding the relationship between risk
and return is essential to understanding why people make some
of the investment decisions they do.
First is the principle that risk and return
are directly related. The greater the risk that an investment
may lose money, the greater its potential for providing a substantial
return. By the same token, the smaller the risk an investment
poses, the smaller the potential return it will provide.
For example, a startup business could become
bankrupt, or it could become a multimillion-dollar company. If
you invest in the stock of this company, you could lose everything
or make a fortune. In contrast, a blue chip company is less likely
to go bankrupt, but you're also less likely to get rich by
buying stock in a company with millions of shareholders.
The second principle is that if you can get
a better-than-average return on an investment with less risk,
you may be willing to sacrifice potentially greater return to
avoid greater risk. That's sometimes the case when interest
rates go up. Investors pull their money out of stocks, which are
more risky, and put it in bonds, which are less risky, because
they're not giving up much in the way of potential return
and they're gaining more safety.
The third principle is that you can balance
risk and return in your overall portfolio by making investments
along the spectrum of risk, from the most to the least.
Diversifying
your portfolio in this way means that some of your investments
have the potential to provide strong returns while others ensure
that part of your principal is secure.
