Financial Concepts: The Risk/Return Tradeoff
The risk/return tradeoff could easily be called the "abilitytosleepatnight test." While some people can handle the equivalent of financial skydiving without batting an eye, others are terrified to climb the financial ladder without a secure harness. Deciding what amount of risk you can take while remaining comfortable with your investments is very important.
In the investing world, the dictionary definition of risk is the chance that an investment's actual return will be different than expected. Technically, this is measured in statistics by standard deviation. Risk means you have the possibility of losing some, or even all, of your original investment.
Low levels of uncertainty (low risk) are associated with low potential returns. High levels of uncertainty (high risk) are associated with high potential returns. The risk/return tradeoff is the balance between the desire for the lowest possible risk and the highest possible return. This is demonstrated graphically in the chart below. A higher standard deviation means a higher risk and higher possible return.
A common misconception is that higher risk equals greater return. The risk/return tradeoff tells us that the higher risk gives us the possibility of higher returns. There are no guarantees. Just as risk means higher potential returns, it also means higher potential losses.
On the lower end of the scale, the riskfree rate of return is represented by the return on U.S. Government Securities because their chance of default is next to nothing. If the riskfree rate is currently 6%, this means, with virtually no risk, we can earn 6% per year on our money.
The common question arises: who wants to earn 6% when index funds average 12% per year over the long run? The answer to this is that even the entire market (represented by the index fund) carries risk. The return on index funds is not 12% every year, but rather 5% one year, 25% the next year, and so on. An investor still faces substantially greater risk and volatility to get an overall return that is higher than a predictable government security. We call this additional return the risk premium, which in this case is 6% (12%  6%).
Determining what risk level is most appropriate for you isn't an easy question to answer. Risk tolerance differs from person to person. Your decision will depend on your goals, income and personal situation, among other factors.
Financial Concepts: Diversification
RiskReturn Tradeoff
The principle that potential return rises with an increase in ... 
Risk
The chance that an investment's actual return will be different ... 
Risk Lover
An investor who is willing to take on additional risk for an ... 
Mean Return
1. In securities analysis, it is the expected value, or mean, ... 
Risk Premium
The return in excess of the riskfree rate of return that an ... 
Characteristic Line
A line formed using regression analysis that summarizes a particular ...

What is the breakdown of subjects covered on the Series 6 exam?
Learn about the riskreturn tradeoff for investing in stocks versus lowrisk Treasurys and bonds, and understand the types ... Read Answer >> 
How can I use risk return tradeoff to determine my risk tolerance and investment ...
Learn how an investor can use the riskreturn tradeoff to determine what assets to include in a portfolio, and understand ... Read Answer >> 
What are some classes I can take to prepare for the Series 6 exam?
Learn about how the riskreturn tradeoff applies to bond yields, and the different types of risks associated with investing ... Read Answer >> 
What metrics should I use to evaluate the risk return tradeoff for a mutual fund?
Understand the key metrics used to analyze mutual funds and how investors can use each measurement to determine the riskreward ... Read Answer >> 
Why is risk return tradeoff important in designing a portfolio?
Learn how the risk return tradeoff is used in the construction of portfolios, and how modern portfolio theory seeks to diversify ... Read Answer >> 
How is the expected market return determined when calculating market risk premium?
Find out how the expected market return rate is determined when calculating market risk premium and how these figures are ... Read Answer >>