Risk, return, and diversification
Every investment carries some risk. Learn what drives that risk, how it connects to potential returns, and how diversification can help balance it out.
You already know that investing is about return. But return has a flip side: risk. In this lesson, you'll learn what that risk looks like — and how to reduce it.
Investing always involves risk
There's no such thing as risk-free investing. Risk and investing go hand in hand — you can't have one without the other. That means as an investor, you always face the possibility of losing some or all of the money you put in. It's why it's so important to only invest money you can afford to lose.
What does risk look like?
Investing means buying something in the hope that it increases in value over time, so you can sell it at a profit. But there's always a chance it goes the other way — that your investment loses value, and you can only sell it at a loss. That possibility — of your investments falling in value and costing you money — is the risk of investing.
Risk and volatility
Not all investments carry the same level of risk. Shares in a company that has been around for decades, built a large and loyal customer base, and operates in a fairly predictable industry are likely to be less risky than shares in a fast-growing start-up introducing a completely new technology.
If you track the value of a stock on a chart, you can get a clear sense of how risky it is. Deep troughs and sharp peaks mean the value swings dramatically — that's a riskier investment. Gentler peaks and shallower troughs suggest something more stable. This movement in an investment's value is known as volatility.
What is volatility?
The intensity with which an investment's value swings over time.
Risk and return
Take another look at that volatile chart. Notice anything? The swings go both ways — the lows are low, but the highs are high. A riskier investment can mean bigger losses, but it can also mean bigger gains.
This leads to one of the most important rules of thumb in investing: the higher the risk, the higher the potential return. And the other way around — the higher the expected return, the higher the risk you're taking on.
As an investor, you're looking for the right balance between risk and return for you. Are you comfortable taking on more risk in exchange for the chance of a higher return? Or do you prefer a more cautious approach, accepting lower returns in exchange for more stability?
Reducing your risk through diversification
There are ways to reduce your risk as an investor. The most important one is diversification — spreading your investments across a range of companies, sectors, and regions rather than concentrating them in one place. If one company, sector, or part of the world runs into trouble, you still have everything else to cushion the blow.
🙎🏽♂️ | 👩🏼💼 | 📉 | 🌏 |
|---|---|---|---|
David goes all in | Sophie spreads her risk | The AI market crashes | Diversification makes a difference |
David invests all his money in one promising AI company. He is convinced that if the company succeeds, its share price will rise sharply. | Sophie divides her money across different companies and sectors — including the same AI company David invested in. | Unexpectedly, the AI market collapses. The company goes bankrupt, and both David and Sophie lose money. | David loses all the money he invested. Sophie, however, still has other shares that have lost less value — or even held their value. |
Key takeaways
- As an investor, you always risk losing some or all of the money you invest.
- Investments with high volatility are riskier; investments with low volatility are more stable.
- The general rule of thumb: higher potential return usually comes with higher risk.
- Diversifying — spreading your investments across different companies, sectors, and regions — is the most effective way to reduce your risk.