Investing: Risk and return (article)

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Risk and return are two important concepts to understand when it comes to investing. Different types of investments have different levels of risk and return, and investors should choose options that match their goals and risk tolerance.

What is risk and return in investing?

When you decide to invest your money, there are two important things to consider: risk and return.

Risk is the uncertainty or variability of the outcome of an investment. In simpler words, it means that there's a chance your investment may not make as much money as you hoped, or you could even lose some or all of your investment.

Return, on the other hand, is the gain or loss from an investment over a period of time. It tells you how much money you made, or lost, on your investment. If you have a positive return, that means your investment has made money. If your return is negative, then you have lost money.

How are risk and return related?

Risk and return are related because generally, the more risk you take with an investment, the higher the potential return. But, taking more risk also means more potential for loss.

Factors that influence risk and return include the type, quality, and duration of the investment, the market conditions, and the investor's behavior. For example, if you invest in a company with a strong track record, your risk might be lower, but so might your return. On the other hand, if you invest in a new company with an unproven track record, you could make a lot of money if the company succeeds, but you also risk losing your entire investment if the company fails.

two arrows, both pointing up. Left arrow reads "risk", right arrow reads "return".

Risk: How can I tell how risky an investment is?

We group investments into three categories: low risk, high risk, and moderate risk and return. It is hard to know how well an investment will do, but there are some general groups we can put them into:

Low-risk, low-return investments: Treasury bills are an example of this type of investment. They are issued by the government and are considered very low-risk, but they also offer lower returns compared to other investments.
High-risk, high-return investments: Penny stocks are an example of this type of investment. These are stocks of small companies that trade at very low prices. They can offer huge returns if the company does well, but they also carry a higher risk of loss.
Moderate-risk, moderate-return investments: Index funds are an example of this type of investment. These are funds that aim to match the performance of a specific market index. They offer diversification and generally have a lower risk than individual stocks, but they can still offer decent returns.

As you can see, we do not have a low-risk, high return (everyone would invest into that) or high-risk, low-return (why would anyone invest into that?). So, remember, risk and return always go hand-in-hand - when one is low, so is the other one, and vice-versa.

Risk & return	Types of investment
Low-risk & low-return	money markets, treasury bills, bonds
Moderate-risk & moderate-return	mutual funds, index funds
High-risk & high-return	stocks, cryptocurrency,

Return: Return on investment (ROI)

Imagine you have $$ 100$ ‍ to invest in something. You know that if you make a good choice, you can turn that $$ 100$ ‍ into even more money. This is where ROI, or Return on Investment, comes in. ROI helps you figure out how much money you've made from an investment compared to how much you put in. So, if you invested your $$ 100$ ‍ and it turned into $$ 150$ ‍, your ROI would be $50 %$ ‍. That means you made $50 %$ ‍ more money than you started with.

Knowing how to calculate ROI can help you decide where to put your money, whether it's a company stock, a business, or even a college savings account. Smart choices today can lead to big rewards tomorrow.

To calculate the return on investment (ROI) for an investment, you can use this simple formula:

$ROI = \frac{Current value of investment - Initial investment}{Initial investment} \times 100$ ‍

For example, if you invested $$ 1,000$ ‍ in a stock and it is now worth $$ 1,200$ ‍, your ROI would be:

$ROI = \frac{$ 1,200 - $ 1,000}{$ 1,000} \times 100 = 20 %$ ‍

$\begin{aligned} ROI & = \frac{$ 1,200 - $ 1,000}{$ 1,000} \times 100 \\ = \frac{$ 200}{$ 1,000} \times 100 \\ = 0.2 \times 100 \\ = 20 % \end{aligned}$ ‍

This means that you made a $20 %$ ‍ return on your investment.

Generally speaking, any number that's positive and over $7 %$ ‍ is a great return and you are definitely making money.

But, also, if you invested $$ 1,000$ ‍ in a stock and it is now worth $$ 900$ ‍, your ROI would be:

$ROI = \frac{$ 900 - $ 1,000}{$ 1,000} \times 100 = - 10 %$ ‍

Is this a good return?

Choose 1 answer:

(Choice A)
yes
(Choice B)
no

A lot of the time, you can find the ROI for different investments online. So, you don't have to do any math. This is helpful when you're trying to decide what to do with your money, like buying stocks or investing in general.

But sometimes, you can't find the ROI on the internet, or you're starting your own business. In that case, it's important to know how to calculate ROI on your own.

Rule of 72

Now that we know what ROI is, we can take investment planning one step further - into the future!

For this, you need the Rule of 72. The Rule of 72 is a simple math formula that helps us estimate how long it will take for our money to double when we invest it. All we have to do is divide the number $72$ ‍ by the interest rate or ROI. The answer we get tells us approximately how many years it'll take for our money to double.

For example, if we invest our money and earn an interest rate of $6 %$ ‍, we would do this: $72 \div 6 = 12$ ‍ years. So, it would take about $12$ ‍ years for our money to double.

Why is the Rule of 72 useful?

The Rule of 72 is helpful because it shows us the power of investing and how our money can grow over time. When we invest, we want our money to grow and make more money for us. By using this simple rule, we can quickly see how long it will take for our money to double at different interest rates.

How can we use the Rule of 72 with ROI?

Remember, ROI helps us figure out how much money an investment makes. We can use the Rule of 72 together with ROI to see how our money should behave in the future.

For example, imagine you invest $$ 500$ ‍ into a mutual fund with an $8 %$ ‍ ROI. You completely forget about it, and about $9$ ‍ years later you check the account and find out that it grew to $$ 1,000$ ‍.

Using the Rule of 72 and the $8 %$ ‍ ROI, we can see that it takes $72 \div 8 = 9$ ‍ years for the money to double. So, in $9$ ‍ years the $$ 500$ ‍ doubled to $$ 1,000$ ‍.

Conclusion

In conclusion, investing is one way to grow your money and reach your goals faster. Remember, higher risks often lead to higher returns, but it's important to be smart about it. Keep the Rule of 72 in mind to quickly estimate how long it'll take to double your investment. Next, start learning about investment options and make your money work for you, as you step into the world of financial growth and success.

Want to join the conversation?

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Leon-Art
10 months agoPosted 10 months ago. Direct link to Leon-Art's post “Why is it 72 specifically...”
Why is it 72 specifically and not any other number?
Button navigates to signup page•Comment on Leon-Art's post “Why is it 72 specifically...”
(8 votes)
- Chase Carnaroli
  10 months agoPosted 10 months ago. Direct link to Chase Carnaroli's post “I asked Khanmigo and this...”
  I asked Khanmigo and this was the response that I got:
  """
  The Rule of 72 is an approximation that comes from the formula for exponential growth.
  The actual formula for the time it takes to double an investment is:
  Time to double = ln(2) / ln(1 + interest rate)
  ln(2) is approximately equal to 0.693.
  For small interest rates, ln(1 + interest rate) is approximately equal to the interest rate itself.
  """
  This makes time to double approximately 0.693 / interest rate.
  Now remember that interest rates are a decimal (8% -> 0.08). In this example, the time to double would be
  0.693 / 0.08.
  That's not easy to calculate in your head though! To simplify it, let's multiple the top and bottom by 100.
  69.3 / 8
  This is a little better but 69.3 is not easy to divide. We'll round up to 72 because that is a much easier number to divide by.
  So finally we are left with
  72 / 8 = 9.
  Although not exact, this approximation is usually good enough to determine how long it will take for your investment to double.
  Comment on Chase Carnaroli's post “I asked Khanmigo and this...”
  (14 votes)
Izzy
7 months agoPosted 7 months ago. Direct link to Izzy's post “_Dear Fellow Students, ...”
Dear Fellow Students,
After I watched the video, I scoured the internet about Penny Stocks (I'm a curious 15-year-old... can you blame me?). I saw a chart with different company statistics on it, read into it, and it looked pretty cool. However, while in the midst of my imaginary hunt for something I couldn't quite name, I found something intriguing...
I saw that a man named Warren Buffet and his accomplice had gotten in trouble with the Federal government for manipulating the price of penny stocks. My question is How Exactly??
I think that paying more than the average $5 per stock would benefit the business. So can someone please explain this to me?
Lots of thanks
- Izzy <3
Button navigates to signup page•Button navigates to signup page
(6 votes)
connor
8 months agoPosted 8 months ago. Direct link to connor's post “SHould I invest in roblox...”
SHould I invest in roblox stock
Button navigates to signup page•Button navigates to signup page
(5 votes)
- Luke Walters
  16 days agoPosted 16 days ago. Direct link to Luke Walters's post “invest in the low taper f...”
  invest in the low taper fade meme cuz it is still MASSIVE!
  Button navigates to signup page
  (2 votes)
Ethan
8 months agoPosted 8 months ago. Direct link to Ethan's post “If penny stocks are high ...”
If penny stocks are high risk, does that mean the relative loss is risky? Since they trade at low prices, you wouldn't lose too much if they fail, but will gain a lot if they succeed, why is this considered "high risk"? Is it the idea that what you put in will likely disappear, even though they aren't particularly expensive?
Button navigates to signup page•Button navigates to signup page
(3 votes)
- Tanner Higham
  9 days agoPosted 9 days ago. Direct link to Tanner Higham's post “I believe they are consid...”
  I believe they are considered high risk because for a set amount of money invested, you could lose much more. Investing less money will mean you won't be able to lose as much.
  Button navigates to signup page
  (1 vote)
Jake
5 months agoPosted 5 months ago. Direct link to Jake's post “At what age should I begi...”
At what age should I begin investing in these financial markets (stocks, bonds, mutual funds, etc.)?
Is there a strategy for a "beginner" investor?
Are there investments that are better (and less riskier) than in financial markets?
Button navigates to signup page•Button navigates to signup page
(1 vote)
- David Alexander
  4 months agoPosted 4 months ago. Direct link to David Alexander's post “I'm assuming that you are...”
  I'm assuming that you are not yet 18 years old, and legally able to invest in your own name. So, either get a trust account where your parents control things for you, or just wait.
  Whatever your age might be, don't begin investing until you have saved the necessary emergency fund.
  Even if you are legally entitled to invest, as a "beginner" you should rely on an advisor, who will charge you some money for the advice, but will help you avoid losing the money based on your own inexperience.
  Comment on David Alexander's post “I'm assuming that you are...”
  (3 votes)
Preston Howard III
8 months agoPosted 8 months ago. Direct link to Preston Howard III's post “Can you make a lot of mon...”
Can you make a lot of money in just one year instead of getting $1,000 every 9 years
Button navigates to signup page•Button navigates to signup page
(1 vote)
- David Alexander
  8 months agoPosted 8 months ago. Direct link to David Alexander's post “Investments can make a lo...”
  Investments can make a lot more than that when done wisely. BUT, investments can also lose it all. So don't be greedy, and understand the risks you are taking.
  Button navigates to signup page
  (3 votes)
Liang
3 days agoPosted 3 days ago. Direct link to Liang's post “If the index fund company...”
If the index fund company that you bought the index fund from goes bust, can you possibly get some percentage of your money back? If so, at what percentage roughly? thx.
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(1 vote)
- David Alexander
  3 days agoPosted 3 days ago. Direct link to David Alexander's post “Investment involves the r...”
  Investment involves the risk of loss. You put your money there, hoping that it would increase, but you bet on the wrong fund. That investment is gone.
  Comment on David Alexander's post “Investment involves the r...”
  (2 votes)
lol
3 months agoPosted 3 months ago. Direct link to lol's post “What is index funds and p...”
What is index funds and penny stocks?
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(1 vote)
JamesB
8 months agoPosted 8 months ago. Direct link to JamesB's post “Should I invest now?”
Should I invest now?
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(1 vote)
- David Alexander
  8 months agoPosted 8 months ago. Direct link to David Alexander's post “You haven't said when "no...”
  You haven't said when "now" is. Are you 13 or 31? The answer will be different depending on your "now".
  Button navigates to signup page
  (1 vote)
CeciliaQ
8 months agoPosted 8 months ago. Direct link to CeciliaQ's post “Why is it 72 specifically...”
Why is it 72 specifically and not any other number?
Button navigates to signup page•Button navigates to signup page
(1 vote)
- David Alexander
  8 months agoPosted 8 months ago. Direct link to David Alexander's post “Actuarial science may hav...”
  Actuarial science may have the answer to that. I'm not an actuary, though.
  Button navigates to signup page
  (1 vote)

FAQs

Investing: Risk and return (article) | Khan Academy? ›

Factors that influence risk and return include the type, quality, and duration of the investment, the market conditions, and the investor's behavior. For example, if you invest in a company with a strong track record, your risk might be lower, but so might your return.

Know More ›

What is the investment risk and return? ›

The concept of risk and return makes reference to the possible economic loss or gain from investing in securities. A gain made by an investor is referred to as a return on their investment. Conversely, the risk signifies the chance or odds that the investor is going to lose money.

Know More ›

What is the primary reason to diversify your investment portfolio at Khan Academy? ›

By diversifying your portfolio, you can reduce risk and increase returns, setting yourself up for a successful financial future.

What is a good return risk? ›

The risk/reward ratio is used by traders and investors to manage their capital and risk of loss. The ratio helps assess the expected return and risk of a given trade. In general, the greater the risk, the greater the expected return demanded. An appropriate risk reward ratio tends to be anything greater than 1:3.

Which risk cannot be avoided completely? ›

Systematic risk is both unpredictable and impossible to completely avoid. It cannot be mitigated through diversification, only through hedging or by using the correct asset allocation strategy. Systematic risk underlies other investment risks, such as industry risk.

Keep Reading ›

What is a fair percentage for an investor? ›

Searching for the magic number

A lot of advisors would argue that for those starting out, the general guiding principle is that you should think about giving away somewhere between 10-20% of equity.

Get More Info ›

What investment strategy is the best? ›

Buy and hold

A buy-and-hold strategy is a classic that's proven itself over and over. With this strategy you do exactly what the name suggests: you buy an investment and then hold it indefinitely. Ideally, you'll never sell the investment, but you should look to own it for at least three to five years.

Discover More Details ›

Should you put all your eggs in one basket when investing? ›

Capital at risk. The value of investments and the income from them can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.

Read On ›

What is the theory of risk and return? ›

The relationship between risk and return is a foundational principle in financial theory. There is a positive correlation between these two variables, the general rule being “the greater the level of risk, the higher the potential return (or loss respectively).

Learn More Now ›

What is risk analysis and return on investment? ›

In financial management, a risk-return analysis determines how much risk is involved in investment relative to its potential rate of return.

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What is meant by an investment's return? ›

Return is a measure of an investment's total interest, dividends and capital gains, expressed as a financial gain or loss over a specific timeframe. Return provides a glimpse of the investment's prior performance and helps determine if a particular investment has been profitable over time.

See Details ›

How do you calculate risk and return? ›

When you're an individual trader in the stock market, one of the few safety devices you have is the risk-reward calculation. The actual calculation to determine risk vs. reward is very easy. You simply divide your net profit (the reward) by the price of your maximum risk.

Get More Info Here ›

What is the risk-return ratio of an investment? ›

The risk/reward ratio—also known as the risk/return ratio—marks the prospective reward an investor can earn for every dollar they risk on an investment. Many investors use risk/reward ratios to compare the expected returns of an investment with the amount of risk they must undertake to earn these returns.

Learn More ›

Investing: Risk and return (article) | Khan Academy (2024)