Risk vs. Return

The first rule of finance is that there is no free lunch. Risk and return are related. You cannot have more return without taking more risk. Risk-free investments yield little or no return (like money market accounts). Very risky investments on average have the potential to yield high returns but are very volatile. You may even lose the entire investment. Thus, risky investments should be held within mutual funds.

There are two kinds of risk.

The first kind of risk can be managed through diversification. If I own an index fund that has 500 big companies (like the S&P 500), one company’s disaster (the BP oil rig explosion, for example) will not affect the index much. If I own BP stock directly, I will get hurt.

The second kind of risk is system-wide. If economic or political events cause the entire market to fluctuate, it affects all stocks.

Diversification does not counteract system-wide risk but can help manage non-system risk.

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