By the end of this lesson you understand what risk means in the context of an investment, and why it isn't the same as "the possibility of losing money."
\nAn investment's risk is the uncertainty about its future outcome: the possibility that the actual result -- what you actually gain or lose -- differs from the result you expected. That deviation can go either down (worse than expected) or up (better than expected); in everyday language, people almost always think of the negative side, but technically risk is uncertainty in both directions, not just the downside.
\nThis distinction matters because it changes the question you should ask before investing. It's not just "can I lose money here?" -- that's true of almost any investment, to some degree -- but "how much can the actual result vary from what I expect, and am I willing to accept that variation?".
\nNo investment is completely free of risk, not even the ones that seem safest. Holding cash without investing it also carries risk: the risk that money loses purchasing power over time if prices in general rise (inflation), even though the number in the account doesn't change. What varies between different options isn't "having risk or not having it," but what type of risk is taken on and to what degree.
\nRisk also isn't uniform across the different asset types you already know from the previous module -- a stock, a bond, a currency, a commodity. Each has a different nature and, therefore, a different uncertainty about its future outcome. The next lessons in this module go deeper into how that risk relates to the return you can expect, and into one of the most common ways of measuring it.
\nInvesting in a small, little-known company with a short financial track record carries more uncertainty about its future outcome than investing in a bond from a government with solid finances and a long history of meeting its payments -- not necessarily because the first one will go badly, but because there's much less information and history to anticipate how it will perform.
\nAn investment's risk is the uncertainty about whether its actual outcome will match the expected one, not just the possibility of losing money. No investment is completely free of it, and its nature varies by asset type.
\nWhy does holding cash also involve taking on some risk?
\nWhat's the difference between "risk" and "probability of losing money"?
","sortOrder":1,"readingMinutes":5,"difficulty":"Básico"},"previous":null,"next":{"id":11,"moduleId":4,"slug":"how-are-risk-and-return-related","title":"How are risk and return related?","summary":"You understand why a higher expected return usually comes with higher risk, and what \"expected\" means in that context.","bodyMarkdown":"## Objectives\n\nBy the end of this lesson you understand why a higher expected return usually comes with higher risk, and what \"expected\" means in that context.\n\n## Content\n\nAn investment's return is the gain -- or loss -- it produces, usually expressed as a percentage of the amount invested. When people talk about \"expected return,\" they aren't talking about a guaranteed outcome, but an estimate: the most likely result, given the risk the investment carries.\n\nIn financial markets there's a general relationship between risk and expected return: to take on more risk, investors demand, in exchange, the possibility of earning more return. The logic is simple -- if two investments offered the same expected return but one carried more risk than the other, everyone would prefer the lower-risk one. This causes market prices to tend to adjust until an investment's extra risk comes with an extra potential return -- otherwise, no one would be willing to take on that extra risk with nothing in exchange.\n\nIt's essential not to confuse \"higher expected return\" with \"higher guaranteed return.\" They're practically opposites: a higher expected return reflects that the range of possible outcomes is wider -- you can gain more, but you can also lose more -- not that you'll necessarily get a better result. Looking only for the investment with the highest possible return, without considering the risk it carries, treats two linked magnitudes as if they were independent.\n\n## Example\n\nA stock and a bond from the same company illustrate this relationship well. The bond offers interest agreed in advance and, barring a default by the company, a fairly predictable outcome. The stock offers no agreed-upon figure: its result depends entirely on how the company performs in the future, and it can vary much more, both for better and for worse. That's why the market generally demands a higher expected return for a stock than for a bond from that same company -- as compensation for the higher risk of having no result agreed in advance.\n\n## Common mistakes\n\n- Thinking \"higher expected return\" means \"higher guaranteed return\" -- it's just the opposite: greater uncertainty about the actual outcome.\n- Looking for the investment with the highest possible return without considering the risk it carries, as if they were independent qualities.\n\n## Summary\n\nTaking on more risk is, generally, the condition for being able to aim for a higher expected return -- never a guarantee of getting it. Risk and expected return are linked, not independent magnitudes.\n\n## Self-check\n\nWhy isn't \"higher expected return\" the same as \"higher guaranteed return\"?\n\nWhy does the market generally demand a higher expected return for a stock than for a bond from the same company?","bodyHtml":"By the end of this lesson you understand why a higher expected return usually comes with higher risk, and what "expected" means in that context.
\nAn investment's return is the gain -- or loss -- it produces, usually expressed as a percentage of the amount invested. When people talk about "expected return," they aren't talking about a guaranteed outcome, but an estimate: the most likely result, given the risk the investment carries.
\nIn financial markets there's a general relationship between risk and expected return: to take on more risk, investors demand, in exchange, the possibility of earning more return. The logic is simple -- if two investments offered the same expected return but one carried more risk than the other, everyone would prefer the lower-risk one. This causes market prices to tend to adjust until an investment's extra risk comes with an extra potential return -- otherwise, no one would be willing to take on that extra risk with nothing in exchange.
\nIt's essential not to confuse "higher expected return" with "higher guaranteed return." They're practically opposites: a higher expected return reflects that the range of possible outcomes is wider -- you can gain more, but you can also lose more -- not that you'll necessarily get a better result. Looking only for the investment with the highest possible return, without considering the risk it carries, treats two linked magnitudes as if they were independent.
\nA stock and a bond from the same company illustrate this relationship well. The bond offers interest agreed in advance and, barring a default by the company, a fairly predictable outcome. The stock offers no agreed-upon figure: its result depends entirely on how the company performs in the future, and it can vary much more, both for better and for worse. That's why the market generally demands a higher expected return for a stock than for a bond from that same company -- as compensation for the higher risk of having no result agreed in advance.
\nTaking on more risk is, generally, the condition for being able to aim for a higher expected return -- never a guarantee of getting it. Risk and expected return are linked, not independent magnitudes.
\nWhy isn't "higher expected return" the same as "higher guaranteed return"?
\nWhy does the market generally demand a higher expected return for a stock than for a bond from the same company?
","sortOrder":2,"readingMinutes":5,"difficulty":"Básico"},"pathContext":null,"curatedLinks":{"prerequisite":[],"continuation":[],"related":[]},"relatedConcepts":[{"concept":{"id":12,"slug":"risk","term":"Risk","shortDefinition":"Uncertainty about an investment's future outcome: the possibility that the actual result will differ from the expected one -- not merely the possibility of losing money.","longDefinition":"An investment's risk is not \"the probability of losing money\" in a strict sense, but the uncertainty about whether the actual result will match the expected one -- that result can be worse than expected, but also better. No investment is completely free of risk, not even holding cash, which carries the risk of losing purchasing power to inflation. Risk isn't uniform across asset types: it varies by issuer, term, and the nature of the instrument. It's directly tied to expected return -- see `return` -- and one way of measuring it, though not the only one, is volatility."}}]}