Risk and Return

Risk is not one thing

Beginners hear 'risk' and think 'the price fell'. Risk has many distinct forms.

• Market risk: broad markets decline together
• Business risk: this specific company deteriorates
• Volatility: how sharply values move day to day
• Permanent loss: value that never comes back
• Temporary decline: value that falls and later recovers
• Liquidity risk: difficulty selling at a fair price
• Concentration risk: too much depends on one holding
• Inflation risk: purchasing power erodes
• Currency and regulatory risk: rules and exchange rates change

Temporary versus permanent

A diversified holding that falls 30% in a downturn and recovers over years experienced a temporary decline. A company that goes bankrupt is a permanent loss.

Confusing the two is expensive in both directions: selling temporary declines locks them in, and refusing to acknowledge permanent damage keeps money in a broken business.

What diversification can and cannot fix

Spreading money across many holdings reduces business risk and concentration risk: one company's failure does much less damage inside a diversified portfolio than inside a concentrated one.

Diversification does not remove market risk. When broad markets fall together, a diversified portfolio falls too, just usually with less severe damage than a single failing holding.

The honest rule

Higher potential returns generally require accepting greater uncertainty or risk. Any offer that claims high returns with no risk is either misunderstood or a fraud.

Related concepts

• Diversification
• Concentration Risk
• Glossary: Maximum drawdown
• Glossary: Diversification