What is risk and return? | Investments and retirement | Financial literacy | Khan Academy

So probably the main thing you will hear when you talk about investing is: What is the return that you got on your investment? Return on investment is often times, people will say ROI, and there's a lot of different ways of calculating it. But maybe the most basic way is to think about if you put $100 into an investment this year and then next year you got back $110. So you got a $10 return on top of your $100 that you invested. People would say that you got a 10% annual ROI or 10% return on investment annually.

Now, it can get more complicated depending on what type of an investment it is and how it pays you out over time, etc. But ROI is a really good thing to think about any investment you make. Generally speaking, you might say, "All right, if there's one thing that gives me 20% ROI or return on investment, that's better than something that gives me a 10% ROI." And if in terms of risk they're similar or the same, then that might very well be the case.

But it turns out that there's usually a trade-off between risk and return. You're usually not going to get a higher return for something that is equally as risky. If that were the case, everyone would invest in that thing and not the thing that's giving the lower return.

To just give an example of how you see that in the real world, you can think of very, very, very safe investments. For example, if you just have your money in a savings or checking account, you might get low single digits—1%, 2%, 3%—on your money depending on where interest rates are, which doesn't feel like a lot, but it's very, very, very safe. If it's less than $250,000 per person per account type, well then you are pretty much guaranteed to get your money back.

So, low risk and arguably low return. If you were to go slightly higher risk, you could do something like lend to the federal government. You lend to the federal government by buying treasury bonds and treasury bills, oftentimes T-bills for short. Now those are pretty much guaranteed to pay you what they say they're going to pay you. So you say, "Okay, why do I get slightly higher interest for that than I get on my checking account?"

Well, it's a little bit less convenient if you need your money right that second. Yes, you could sell those treasury bills or treasury bonds, but those prices do fluctuate. So you're only guaranteed to get the money plus the interest if you hold it all the way, all the way to however long that treasury bond or treasury bill was for. It might be for one year, two years, or 10 years, or whatever it is.

There's a certain risk, not just for the price fluctuations, but also regarding how accessible that money is. For example, in that checking or savings account, if you want that money, you can usually get it within a business, within a working day—usually in a matter of hours. If you have a treasury bond or treasury bill, it's a little bit more complicated and you're going to have more of those price fluctuations.

Now, if you wanted to go up the risk and return ladder a little bit more, you could lend to other entities. You could lend to big safe companies. They will pay you higher interest than the federal government will, but there's a little bit more risk that they might not pay that loan back. Maybe they go out of business, maybe something dramatically negative happens to their business.

What you'll generally see is that as you go to riskier and riskier companies, they're going to pay higher and higher interest on their bonds. If you look at the stock market, where you're actually buying a share—when you buy a stock, you're buying a piece of the company—you'll normally see that the companies that feel pretty, pretty risky, they might feel like they could have a higher return, but they could also have a much higher loss as well.

While companies that are safer, in general speaking, you would expect to have lower risk and also lower return. So, it's important to think about return on investment when you make an investment. And it's very, very, very, very important to think about risk. I can't stress this enough.

How many people have explained, they're like, "Oh, I have a 30% guaranteed ROI investment." I'm like, "Okay, someone's lying to you." Because if it was 30% ROI guaranteed, you would have all of the major investment funds in the world just investing in that. Why would they let little old us invest, or your uncle? Why would they let you invest in that if it was really 30% guaranteed?

I would be very skeptical of people who say something like that. There's usually a risk that that person isn't thinking about, or that return is in some ways shady or fabricated, which also makes me feel that that whole proposition is even riskier. So, there are definitely ways that you can get 10%, 20%, 30% return, but it's usually associated with a decent dose of risk.

When you go into something like that, also think about the worst-case scenario. It's easy to dream about making all the money, but think about what would happen if you lost 30%, or 50%, or 80% of your money. How would you feel then? And then invest accordingly.