There is a positive correlation between risk and return with one important caveat. There is no guarantee that taking greater risk results in a greater return. Rather, taking greater risk may result in the loss of a larger amount of capital. A more correct statement may be that there is a positive correlation between the amount of risk and the potential for return. Generally, a lower risk investment has a lower potential for profit. A higher risk investment has a higher potential for profit but also a potential for a greater loss.
Risk and Investments
The risk associated with investments can be thought of as lying along a spectrum. On the low-risk end, there are short-term government bonds with low yields. The middle of the spectrum may contain investments such as rental property or high-yield debt. On the high-risk end of the spectrum are equity investments, futures and commodity contracts, including options. Investments with different levels of risk are often placed together in a portfolio to maximize returns while minimizing the possibility of volatility and loss. Modern portfolio theory (MPT) uses statistical techniques to determine an efficient frontier that results in the lowest risk for a given rate of return. Using the concepts of this theory, assets are combined in a portfolio based on statistical measurements such as standard deviation and correlation.
An investor needs to understand his individual risk tolerance when constructing a portfolio of assets. Risk tolerance varies among investors. Factors that impact risk tolerance may include the amount of time to retirement for the investor, the size of the portfolio, future earnings potential and other types of assets such as a home or pension.