Risk refers to the degree to which an investor may lose his or her investment. Return refers to how an investment performs; that is how much it gains or loses over a period of time.
Different types of asset classes, such as stocks, bonds, and money market securities, have varying levels of risk and return potential. Generally, the higher the potential return on an investment, the higher the risk involved in pursuing that return. This is called risk/return tradeoff. While some people can handle the equivalent of financial rollers-coaster, 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.
Your investments are subject to varying degrees of specific risk, market risk, and inflation risk.
Whereas market risk (systematic risk) affects a broad range of securities, specific risk (unsystematic risk) affects a very specific group of securities or an individual security.
Generally, as the market risk of an investment increases, its inflation risk decreases, and vice versa.
Extraordinary gains are won only through excessive risk taking, which often means tremendous volatility that is ups and downs in short-term returns. While no single risk measure can predict with 100% accuracy how volatile security will be in the future, studies have shown that past risk is a pretty good indicator of future risk. In other words, if a security has been volatile in the past, it's likely to be volatile in the future.
Two common yardsticks for measuring a security's risk are standard deviation and beta. While the standard deviation of a security measure the total risk, which is both the specific risk and market risk, the beta of a security is a measure of how much market risk a security faces
You can manage your exposure to investment risks through proper diversification and asset allocation.
Specific risk can be reduced or virtually eliminated from a portfolio through appropriate diversification. Investing in many different assets reduces the volatility of the portfolio because up and down of individual asset cancel each other out.
Because the specific risk can be eliminated, the really matter is market risk. Investors reward only market risk. Market risk can’t be eliminated through diversification, but can be managed and reduced by asset allocation. There is a trade-off between risk and return for asset classes. Historically, stocks had higher risk and return than bonds had.
Market risk and inflation risk should be balanced according to investment time horizon. For instance: