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The Tradeoffs Between Return and Risk

The Tradeoffs between Return and Risk

The discussion of financial investments has emphasized the expected rate of return, the risk, and the liquidity of each investment. This table summarizes these characteristics.

Key Characteristics for Financial Investments

Financial InvestmentReturnRiskLiquidity
Checking accountVery lowVery littleVery high
Savings accountLowVery littleHigh
Certificate of depositLow to mediumVery littleMedium
StocksHighMedium to highMedium
BondsMediumLow to mediumMedium
Mutual fundsMedium to highMedium to highMedium to high
CollectiblesLow to mediumHighLow

The household investment choices listed here display a tradeoff between the expected return and the degree of risk involved. Bank accounts have very low risk and very low returns; bonds have higher risk but higher returns; and stocks are riskiest of all but have the potential for still higher returns. In effect, the higher average return compensates for the higher degree of risk. If risky assets like stocks did not also offer a higher average return, then few investors would want them.

This tradeoff between return and risk complicates the task of any financial investor: Is it better to invest safely or to take a risk and go for the high return? Ultimately, choices about risk and return will be based on personal preferences. However, it is often useful to examine risk and return in the context of different time frames.

The high returns of stock market investments refer to a high average return that can be expected over a period of several years or decades. The high risk of such investments refers to the fact that in shorter time frames, from months to a few years, the rate of return may fluctuate a great deal. Thus, a person near retirement age, who already owns a house, may prefer reduced risk and certainty about retirement income. For young workers, just starting to make a reasonably profitable living, it may make sense to put most of their savings for retirement in stocks. Stocks are risky in the short term, to be sure, but when the worker can look forward to several decades during which stock market ups and downs can even out, stocks will typically pay a much higher return over that extended period than will bonds or bank accounts. Thus, tradeoffs between risk and return must be considered in the context of where the investor is in life.

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