Risk and return: the gravity of investing

There is no free lunch

Every investment offers you a deal: the chance of a higher return in exchange for accepting more uncertainty. Cash in an insured savings account will not drop in value, but it grows slowly. Stocks have historically grown much faster, but they can fall hard and fast. This risk/return tradeoff is the closest thing finance has to a law of gravity.

Investors usually describe the bumpiness as volatility: how far and how fast prices swing. A broad U.S. stock index like the S&P 500 has historically returned roughly 10% a year on average before inflation, but that average hides a wild ride. It lost about 37% in 2008 and gained more than 30% in several other years. The long-run average only goes to people who stay on board for the whole trip, and it is never guaranteed.

The math of losses

Losses hurt more than gains help, and not only emotionally. A drawdown is the drop from a peak to a low, and recovering from one takes a bigger percentage gain than the loss itself:

• Down 10%: you need about +11% to get back to even.
• Down 20%: you need +25%.
• Down 50%: you need +100%.

Say $10,000 falls 50% to $5,000. A 50% gain only brings it back to $7,500; it takes a full doubling to reach $10,000 again. That is why avoiding catastrophic losses matters as much as chasing big gains.

Time changes the picture

Over months, stocks are unpredictable. Over decades, they have been far more dependable, though never guaranteed. The S&P 500 fell about 57% from its 2007 peak to its 2009 low during the financial crisis, then reached new highs about four years later. On the other hand, the 2000s ended with large U.S. stocks slightly below where they began, a reminder that even ten years is not always enough.

That is why your time horizon, how long until you need the money, is the first question to ask. A down payment you need in 18 months belongs somewhere stable. Retirement money you will not touch for 30 years can usually ride out several bear markets along the way.

Know your real risk tolerance

Your risk tolerance has two parts:

• Ability: can your finances absorb a loss? Stable income, an emergency fund and no high-interest debt all raise it.
• Willingness: can your nerves absorb it? Plenty of people who call themselves aggressive discover otherwise during their first 30% drop.

The right amount of risk is the amount you can hold through a bad year without selling at the bottom. A slightly conservative portfolio you stick with will usually beat an aggressive one you abandon in a panic. Spreading money across different assets, called diversification, is the main tool for taking risk more wisely; it gets its own lesson in Diversification and allocation.

Curious how nervous the market feels today? The VIX on the Pulse dashboard tracks expected stock-market volatility.