BA-102 · Lesson 7 of 9

Return and Risk

Understand why a higher potential return comes with higher risk and how time horizon and diversification help you.

13 min read Beginner Shares and Bonds Made Simple
Track contents Introduction to the Capital Market
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BA-101 · First Steps on the Stock ExchangeWhat Is the Capital MarketHow a Stock Exchange WorksMarket ParticipantsBIMx: The Stock Exchange of the Republic of Moldova
BA-102 · Shares and Bonds Made SimpleSharesBondsReturn and Risk
BA-103 · How to Open an Account with a BrokerChoosing a Broker and Opening an AccountOrder Types and Your First Trade

The risk–return relationship

One of the most important ideas in finance is that there is no return without risk. Investors agree to take on more risk only if they have the prospect of a higher potential gain. That is why instruments that promise high returns are almost always riskier as well.

Return on an investment
Return (%) = (Final value − Initial value + Income received) ÷ Initial value × 100
Income received can be dividends or coupons. For a realistic picture, subtract commissions and taxes.
InstrumentOverall riskPotential returnValue fluctuation
Bank depositLowLowVery small
Government bondsLow to moderateLow to moderateSmall to moderate
Corporate bondsModerateModerateModerate
SharesHighHighLarge

The table above is a general, indicative comparison. In practice, risk depends on each individual issuer and instrument: a bond from a fragile company can be riskier than the shares of a solid one.

Types of risk

  • Market risk – prices fall because of general factors, such as an economic slowdown.
  • Issuer-specific risk – a particular company runs into problems, for example it loses important customers.
  • Credit risk – a bond issuer fails to pay the coupons or the face value.
  • Liquidity risk – you cannot find buyers at a reasonable price when you want to sell.
  • Interest rate risk – rising interest rates reduce the price of existing bonds.
  • Currency risk – if you invest in another currency, changes in its exchange rate against the leu can reduce your gain.
  • Inflation risk – rising prices reduce the purchasing power of the money you earn.

Inflation and time horizon

The stated return on an investment is a nominal return. What really matters for your purchasing power is the real return, that is, the return after taking inflation into account.

Real return (approximation)
Real return ≈ Nominal return − Inflation rate
The approximation works well for low values of inflation and return.

Your time horizon is the period for which you can leave your money invested without needing it. The longer the horizon, the more time you have to ride out temporary price declines. Money you will need soon, for example for a planned expense in a few months, is usually better suited to instruments with small value fluctuations.

Diversification in brief

The saying "don't put all your eggs in one basket" sums up the idea of diversification: you spread your money across several instruments, issuers or sectors, so that a problem with one of them does not seriously hurt your whole portfolio.

Key takeaways

  • A higher potential return usually comes with higher risk.
  • The main risks are market, issuer-specific, credit, liquidity, interest rate, currency and inflation risk.
  • The real return is obtained, approximately, by subtracting inflation from the nominal return.
  • A longer time horizon gives you more room to ride out temporary declines.
  • Diversification reduces issuer-specific risk, but it does not eliminate market risk.

Check your knowledge

Answer all the questions. If you answer all of them correctly, the lesson is marked as completed automatically.

Question 1 of 3An investment delivers a nominal return of 9% in a year when inflation is 6%. What is the approximate real return?

Explanation: Real return ≈ nominal return − inflation = 9% − 6% = 3%.

Question 2 of 3Which type of risk does diversification across several issuers mainly reduce?

Explanation: Diversification limits the impact of problems at a single company, but it does not protect against a general market decline or inflation.

Question 3 of 3Someone promises you a very high return that is completely risk-free. Based on the risk–return relationship, how should you react?

Explanation: Potentially high returns generally come with high risks; promises of high guaranteed gains are a red flag.

Finished the lesson?Mark it as completed to track your progress.

Educational material only. It does not constitute investment, legal or tax advice. Numerical examples are hypothetical.