The Relationship Between Return and Risk

Return is a key (maybe the key) to long-term investing.  The return is the interest earned on the 'principal' or amount invested.  Return often varies based on the type of investment, and broadly there are two types of investment:

A) Investments where the capital is at no risk

and

B) Investments that include risk to the capital  

The 'A' investments have no downside risk and typically provide modest returns; think savings accounts, CDs, and Money Markets. That's why checking the balance of your savings account is quite dull; the balance doesn't vary higher or lower much unless you make deposits or withdrawals.  The balance instead steadily increases a tiny bit each month.  The return you earn on these investments is called 'risk-free return'.  It is typically quite small. In most of these accounts, the principal is actually insured against loss (at no cost to you) by the Federal Deposit Insurance Corporation, or FDIC. This guarantees the principal in your account (up to a quarter million dollars) to prevent runs on banks like depicted in the classic Christmas movie It’s a Wonderful Life.

The 'B' investments are 'risk-bearing', meaning that the capital invested shrinks and expands over time. They're volatile, meaning (at least in financial field) that they vary in value over time.  Sometime higher, sometimes lower. When capital is at risk, investors must be rewarded for assuming that risk. Otherwise, why would investors be interested?  The reward for taking on risk in the ‘B’ investments is called 'risk premium'.  The return on these category B investments is the risk premium added to the risk-free return. In equation form, that’s:

Total Return = Risk-free return + Risk Premium

There are three broad categories of investments typically considered when investing for the long term:

Equities, Bonds, and Cash Equivalents.  

We'll discuss each below, and each have different volatility and liquidity characteristics. If you'd like an intro (or a brush up) on volatility and liquidity, see immediately below. 

Stocks

Equity investing (also known as stocks) exchanges money for partial ownership in a company. Companies sell portions of ownership in the company in order to raise money for company.  

Equity investing is the most volatile of the three categories, and therefore has historically returned the largest risk premium.

Bonds

Bond investing loans money to company or government. Instead of selling portions of ownership in the company in order to raise money, investors lend money and then get paid back at an interest rate.  

Bond prices vary based on the credit quality of the issuer, the length of time until expiration, and the bond's interest rate (called 'coupon rate') compared to the interest rate environment at the time.

Bond investing is less volatile than equity investing but has had historically lower returns.

Cash Equivalents

Cash equivalents are a low-risk, low-return, low-volatility.  They are great to hold in the short term because of their liquidity, but are generally a poor choice as a long-term investment because of their low returns.  

The saying 'cash is expensive' refers to the opportunity cost of holding cash instead of using that cash to invest in something that provides a higher return.