What Is Risk and Return?

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April is Financial Literacy Month, and our goal is to help you raise your money IQ. In this series, we'll tackle key economic concepts -- ones that affect your everyday finances and investments -- to help you make smarter choices with every dollar decision you face.

Today's concept: risk and return.

When it comes to financial matters, we all know what risk is -- the possibility of losing your hard-earned cash. And most of us understand that a return is what you make on an investment. What many people don't understand, though, is the relationship between the two.

Trade-offs

The relationship between risk and return is often represented by a trade-off. In general, the more risk you take on, the greater your possible return. Think of lottery tickets, for example. They involve a very high risk (of losing your money) and the possibility of an extremely high reward (the giant check with lots of zeroes). Or penny stocks: They're also very risky and yet seem full of amazing potential.

At the other end of the spectrum are options such as a savings account at your bank, or buying government bonds. They're quite low-risk, but you're not going to make a mint on them, either -- at least not these days, with interest rates so low.

Your personal risk tolerance can affect how much risk you take on, but sometimes a lack of information can get in the way and influence you, too.

Getting the Facts

Let's review the examples above.

Ironically, lotteries are presented as low-risk, high-return propositions. But they're really more like very high-risk, very low-return ones. Sure, all you have to do is shell out a few bucks for a ticket that might pay you a multimillion-dollar jackpot. But you're really much, much, much more likely to just lose all of the cost of the ticket. With the Powerball lottery, the odds of winning the jackpot are 1 in 175,223,510. Flip that around and you'll see that your odds of losing are 175,223,509 in 175,223,510 -- or, about 99.9999994 percent. And while you might win a lesser prize, overall, in the long run of buying tickets, you'll likely collect only about 60 cents or so for every dollar you spend.

Penny stocks, those trading for less than $5 or so per share, seem much more sensible than lottery tickets because they're tied to companies that are described as likely to grow in value. There's also excitement due to their low price: Being able to buy, say, 1,000 shares for just a few hundred dollars can make you feel rich. But penny stocks are often (though not always) tied to companies that have not proven themselves. Instead of track records of sales and profits, they tend to mainly offer the chance of riches, as they drill for oil or aim to cure cancer. They're also easily manipulated since there are relatively few shares of each issue. Thus, you stand a decent chance of doing worse investing in penny stocks than even with lottery tickets!

Less Risk, Lower Return

On what seems like the more sensible side of the spectrum are bank accounts and government bonds. Are they low-risk? Absolutely. But their returns are low, too.

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According to Bankrate.com, the average money market account has recently been yielding about 0.5 percent, and you can collect as much as 1.2 percent on a two-year CD. That might sound slightly good, but when you factor in inflation, which tends to average close to 3 percent annually, you'll see that you're actually losing purchasing power over time with such investments. So, while you know at the end of the CD term you'll have made 1.2 percent on your investment, you also must recognize that with the the apparently low-risk investment comes the apparently high risk that you won't keep up with inflation.

In your Life

Risk and return play a part in our nonfinancial lives, as well. Think of that lovely person you'd like to date, for example. Asking him or her out involves the risk of being turned down or embarrassed. But the possible return is significant, too, if you end up in a meaningful relationship.

The principle even applies at restaurants. Take a chance on a menu item you've never tried and can't pronounce instead of your safe and boring usual order. It's riskier, but you might discover a new favorite.

Find Balance

When it comes to your money and the financial decisions you make, the more informed you are, the more rationally you'll be able to assess risk and return.

In many cases, you'll want to aim for the middle of the spectrum, taking on a moderate level of risk in exchange for a moderate return. You can do that by spreading your money around -- for example, including a mix of stocks and bonds in your portfolio. It's via smart asset allocation that you'll make sure not to overexpose yourself to risk while getting the best reward possible.

Learning about some simple economic concepts can make you a better financial thinker and decision maker.

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Financial Terms You Need to Know
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What Is Risk and Return?

In a nutshell, net worth is what you get when you subtract liabilities from assets -- what you owe from what you own. Like many economic and financial terms, net worth can apply in a variety of situations.

If you're evaluating a company for your portfolio,you might glance at its balance sheet to get a handle on its net worth. Balance sheets break out assets (such as cash, inventory, and receivables) and liabilities (such as debt and accounts payable). Subtracting the latter from the former gives you net worth, which is also referred to in this context as shareholders' equity or book value.

Here's an example: As of the end of 2012, IBM's (IBM) assets totaled $119 billion, and its liabilities totaled $100 billion. Thus, its net worth, or shareholders' equity, was $19 billion.

Read more on Asset Allocation.

You probably think you've got the term down pat: Inflation means prices rising over time. Well, yes, that's pretty much right. But there's much more to inflation, and it's much more relevant to your life than you might think. Inflation can go in the opposite direction, for example, and it can spiral out of control.

Inflation is about purchasing power. It's a way to measure the changing purchasing power of our currency by tracking changes in the prices of things we buy. The national banks of various countries try to keep inflation under control through their actions and policies (such as via the interest rates they set); many aim for an annual inflation rate of about 2 percent to 3 percent.

While the concept of inflation seems simple it's actually a bit more complicated. Read more on inflation here.

Most of us are familiar with the term, and have a basic grasp of it. It refers to how a project or decision might be evaluated, comparing its costs with its benefits. In many cases, it's a like a quantified pros-and-cons list.

Applying cost-benefit analyses in the business world and your own personal finances can be very effective, helping decision makers avoid just going with their gut or with very rough calculations.

Read More About Cost-Benefit Analysis

Simply put, it's what you give up in order to do something. Imagine, for example, that you dream of becoming an engineer or a chef. If you opt to become a chef, you give up the experience of being an engineer and all that goes with it. That's an opportunity cost of becoming a chef.

Opportunity cost is also often defined, more specifically, as the highest-value opportunity forgone. So let's say you could have become a brain surgeon, earning $250,000 per year, instead of a chef earning $50,000. In that scenario, your opportunity cost, salary-wise, is $200,000. (Of course, you should also consider factors such as your enjoyment of your chosen profession.)

Read more on Opportunity Costs.

Most folks are familiar with the concept of supply and demand, but most of us also don't give it much thought, which is a mistake. That's because it applies to much more than just business.

First, to review. In basic economics, the law of supply and demand influences prices. If supply of an item is abundant, that will pressure the price downward, and vice versa. In practice, imagine that you're the only one in town selling shoehorns. Because consumers don't have any other places to buy the product, that gives you some pricing power. But if other stores in town start carrying shoehorns, you may have to drop your price to keep customers coming.

Read about the differences of supply and demand in the stock market and in our own lives here.

As the name suggests, sunk cost refers to money that has already been invested in something, money that can't be recovered. Too often, we factor that expense into our financial decision-making when we shouldn't.

Let's say you've spent $40 on a nonrefundable ticket to the theater for tomorrow night. And you're suddenly invited to play board games at a friend's house that same evening. You might think that you should go to the theater -- after all, you spent that $40 -- even though what you'd rather do is hang out with your friends and play games. The $40 is a sunk cost. It's spent, whether you go see the play or not, and the money doesn't know the difference. So you should do whatever you would rather do.

Read more on Sunk Cost.

In the most basic sense, asset allocation is simply how one's assets are divided among different asset classes, such as cash, stocks, bonds, real estate, and so on -- even insurance investments, commodities, collectibles, and other categories count.

But the term also refers to an investment strategy -- one that can reduce risk through diversification.

Clearly, having all your money in any one asset class can be risky. In 2008, the S&P 500 plunged 37 percent. If you'd held all your assets in an S&P 500 index fund, your net worth would have taken a big hit that year.

Given the harrowing ride we've been on in recent years, you might think that holding cash is the best way to protect your assets from outside forces. Think again.

Continue reading about Asset Allocation.

The concept of interest is familiar to most of us. We know that with many bank accounts, for example, we earn some interest -- though it's rather paltry these days.

But there are several kinds of interest that are calculated and represented quite differently than simple interest. Compound interest is -- pardon the pun -- one of the more interesting ones.

First, let's start with simple interest. Here's how it works: Let's say that you've parked $1,000 in an account somewhere, earning 10 percent per year in simple interest. In year one, you'll collect $100, bringing your total to $1,100. Great, eh? In year two, you get... $100. That brings your total to $1,200. In year three, you're at $1,300. You're probably catching on to the idea by now. You keep earning that interest rate off your initial principal.

Enter compound interest, which is far more exciting.

Continue reading on Compound Interest.

The meaning of the term varies depending on context. In the accounting world, for example, it refers to the change in a company's cash level over a specific period of time. If a company's cash level rises during that period, it's exhibiting positive cash flow. If it shrinks, negative cash flow.

When investors study companies to see if they might be good fits for their portfolios, they may assess "free cash flow." That reflects a company's cash flow from its operations after it pays all its expenses. Free cash flow can be viewed as the lifeblood of a company.

Read more on Cash Flow.

When it comes to financial matters, we all know what risk is -- the possibility of losing your hard-earned cash. And most of us understand that a return is what you make on an investment. What many people don't understand, though, is the relationship between the two.

The relationship between risk and return is often represented by a trade-off. In general, the more risk you take on, the greater your possible return. Think of lottery tickets, for example. They involve a very high risk (of losing your money) and the possibility of an extremely high reward (the giant check with lots of zeroes). Or penny stocks: They're also very risky and yet seem full of amazing potential.

At the other end of the spectrum are options such as a savings account at your bank, or buying government bonds. They're quite low-risk, but you're not going to make a mint on them, either -- at least not these days, with interest rates so low.

Learn more about Risk and Return.

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