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Understand the Risk and Return History of the Major Asset Classes

Investing entails risk, and risk means different things to different investors. Risk could mean the possibility of losing all your money. It could also mean the possibility of losing principal. Risk could also entail the possibility of not achieving a specific holding-period return. Risk has many different meanings.

Risk is measured in many different ways. In the past, the main risk of investing was considered to be “default risk,” or the risk that a company would not be able to pay back an investment due to default or bankruptcy. Government securities were considered risk-free investments, because investors knew the government could always print money.

In more recent years, analysts began to use variance, or standard deviation, to better measure risk; they found that even government securities are risky. This measure of risk is not concerned with the possibility of default; rather, it is concerned with the volatility of the investments, or the risk that the investment’s return may be lower than expected. Currently, investors also use a metric known as beta, which measures the way a specific stock moves in relation to a specific market or benchmark.

Generally, most investors prefer to use standard deviation or beta to measure risk. Both are measures of how volatile a stock is—how much it moves both up and down. In the case of beta, risk is also measured by how much the stock moves in comparison to a specific benchmark. A lower standard deviation indicates that the price does not move very much. A higher standard deviation indicates that the price moves a lot in comparison to the benchmark. A beta higher than one indicates that the stock is more volatile than the market; a beta less than one indicates that the stock is less volatile than the market; a beta of exactly one indicates that a stock moves with the market. When you look at a stock’s returns, you should always look at risk (standard deviation or beta versus the market) of the stock as well. Generally, higher returns carry higher risks because investors must be compensated for taking on additional risk.

There are a few important concepts you should understand related to risk:

  • Investment risk is the probability of not achieving some specific return objective.
  • The risk-free rate is the rate of return that will definitely be obtained.  It is often assumed to be the return on U.S. treasury securities.
  • The risk premium is the difference between the expected return and the risk-free rate.
  • Risk aversion is the reluctance of an investor to accept risk.

There is a difference between investing and gambling. Investors are willing to assume risk because they expect to earn a risk premium when they invest; in other words, the odds are in the investor’s favor because there is a favorable risk-return trade-off.

Gamblers are different from investors in that they are willing to assume risk even when there is no prospect of a risk premium—in other words, the odds are not in the gambler’s favor because there is no favorable risk-return trade-off.


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