beginner lesson • 10 min
Understanding Investment Risk
What you will learn
By the end of this lesson, you should be able to define investment risk, recognize several common types of risk, explain the general relationship between potential return and potential risk, and describe how asset allocation and diversification can help manage risk without eliminating it.
Evidence & citations8 sources
Investment risk is the possibility that an investment produces a negative financial outcome or otherwise harms an investor’s financial welfare. (supported)
Investment risk can include market risk, business risk, liquidity risk, inflation risk, currency risk, political risk, and concentration risk. (supported)
Higher potential returns are generally associated with greater potential risk, but the relationship does not guarantee that a riskier investment will earn a higher return. (supported)
Asset allocation means dividing investments among asset classes such as stocks, bonds, and cash, and the appropriate allocation depends partly on time horizon and risk tolerance. (supported)
Diversification means spreading investments across different investments or asset classes to reduce exposure to any one investment or concentration risk. (supported)
Diversification can reduce some investment risks but cannot eliminate risks that affect the broader market or economy. (supported)
Investment risk in simple terms
Imagine putting money into something that might become worth less later. That possibility is investment risk. Every investment has some risk, so you may lose part or all of the money invested. Spreading money among different investments can reduce the damage caused by one investment performing poorly, but it cannot protect against every problem, such as a broad market or economic decline.
Evidence & citations6 sources
Investment risk is the possibility that an investment produces a negative financial outcome or otherwise harms an investor’s financial welfare. (supported)
All investments involve some degree of risk, and an investment can lose part or all of its value. (supported)
Diversification means spreading investments across different investments or asset classes to reduce exposure to any one investment or concentration risk. (supported)
Diversification can reduce some investment risks but cannot eliminate risks that affect the broader market or economy. (supported)
What is investment risk?
Investment risk is the possibility that an investment produces a negative financial outcome or otherwise harms an investor’s financial welfare. Risk is not limited to a temporary change in price: it can include different ways an investment may fail to meet an investor’s financial needs. All investments involve some degree of risk, and an investment can lose part or all of its value.
Evidence & citations3 sources
Investment risk is the possibility that an investment produces a negative financial outcome or otherwise harms an investor’s financial welfare. (supported)
All investments involve some degree of risk, and an investment can lose part or all of its value. (supported)
Different forms of investment risk
Investment risk can come from several sources. Market risk is the possibility that broader market conditions affect value. Business risk relates to problems involving a company or issuer. Liquidity risk concerns difficulty related to accessing or selling an investment. Inflation risk is the risk that inflation affects the value of money or an investment outcome. Currency and political risks can matter especially for international investments. Concentration risk arises when too much is invested in one holding or area. These risks can overlap, and an investment may face more than one of them at the same time.
Evidence & citations4 sources
Investment risk can include market risk, business risk, liquidity risk, inflation risk, currency risk, political risk, and concentration risk. (supported)
How investors can think about managing risk
A common general tradeoff is that higher potential returns are associated with greater potential risk. This is not a promise: a riskier investment is not guaranteed to earn a higher return. Asset allocation means dividing investments among asset classes such as stocks, bonds, and cash. An appropriate allocation depends partly on an investor’s time horizon and risk tolerance. Diversification means spreading investments across different investments or asset classes to reduce exposure to any one investment or concentration risk. These approaches manage exposure to risk; they do not make an investment risk-free.
Evidence & citations5 sources
Higher potential returns are generally associated with greater potential risk, but the relationship does not guarantee that a riskier investment will earn a higher return. (supported)
Asset allocation means dividing investments among asset classes such as stocks, bonds, and cash, and the appropriate allocation depends partly on time horizon and risk tolerance. (supported)
Diversification means spreading investments across different investments or asset classes to reduce exposure to any one investment or concentration risk. (supported)
Diversification can reduce some investment risks but cannot eliminate risks that affect the broader market or economy. (supported)
A simple example of concentration and diversification
Suppose an investor puts money into only one investment. If that investment experiences a problem, the investor has concentrated exposure to that problem. If instead the investor spreads money across different investments or asset classes, a problem affecting only one holding may have less effect on the overall group. However, if a decline affects the broader market or economy, diversification cannot guarantee that the group will avoid losses. This example illustrates risk management, not a recommendation for a particular investment.
Evidence & citations4 sources
Diversification means spreading investments across different investments or asset classes to reduce exposure to any one investment or concentration risk. (supported)
Diversification can reduce some investment risks but cannot eliminate risks that affect the broader market or economy. (supported)
Important limits and cautions
Diversification can reduce some risks, especially risks connected with concentrating money in one investment or asset class, but it cannot eliminate risks affecting the broader market or economy. A longer time horizon may make market fluctuations easier for an investor to tolerate, but simply holding a risky investment longer does not make it risk-free. Because every investment involves risk, risk should be considered alongside an investor’s time horizon and risk tolerance.
Evidence & citations5 sources
Diversification can reduce some investment risks but cannot eliminate risks that affect the broader market or economy. (supported)
A longer investment time horizon may make it easier for an investor to tolerate market fluctuations, but holding an investment longer does not make a risky investment risk-free. (supported)
All investments involve some degree of risk, and an investment can lose part or all of its value. (supported)
Asset allocation means dividing investments among asset classes such as stocks, bonds, and cash, and the appropriate allocation depends partly on time horizon and risk tolerance. (supported)
Common misconceptions
• “There is a risk-free investment.” Every investment involves some degree of risk, and an investment can lose part or all of its value.
• “Higher risk guarantees higher returns.” Higher potential returns are generally associated with greater potential risk, but a riskier investment is not guaranteed to earn a higher return.
• “Diversification prevents losses.” Diversification can reduce some risks, but it cannot eliminate risks that affect the broader market or economy.
• “Holding an investment longer makes it safe.” A longer time horizon may help an investor tolerate fluctuations, but a risky investment does not become risk-free simply because it is held longer.
Evidence & citations5 sources
All investments involve some degree of risk, and an investment can lose part or all of its value. (supported)
Higher potential returns are generally associated with greater potential risk, but the relationship does not guarantee that a riskier investment will earn a higher return. (supported)
Diversification can reduce some investment risks but cannot eliminate risks that affect the broader market or economy. (supported)
A longer investment time horizon may make it easier for an investor to tolerate market fluctuations, but holding an investment longer does not make a risky investment risk-free. (supported)
Key takeaways
Investment risk is the possibility of financial loss or another negative effect on financial welfare. All investments carry risk. Risk may arise from markets, businesses, liquidity, inflation, currencies, politics, or concentration. Higher potential return generally comes with higher potential risk, but no return is guaranteed. Asset allocation and diversification can help manage exposure, while time horizon and risk tolerance help inform how an investor thinks about that exposure. None of these ideas eliminates investment risk.
Evidence & citations8 sources
Investment risk is the possibility that an investment produces a negative financial outcome or otherwise harms an investor’s financial welfare. (supported)
All investments involve some degree of risk, and an investment can lose part or all of its value. (supported)
Investment risk can include market risk, business risk, liquidity risk, inflation risk, currency risk, political risk, and concentration risk. (supported)
Higher potential returns are generally associated with greater potential risk, but the relationship does not guarantee that a riskier investment will earn a higher return. (supported)
Asset allocation means dividing investments among asset classes such as stocks, bonds, and cash, and the appropriate allocation depends partly on time horizon and risk tolerance. (supported)
Diversification means spreading investments across different investments or asset classes to reduce exposure to any one investment or concentration risk. (supported)
Diversification can reduce some investment risks but cannot eliminate risks that affect the broader market or economy. (supported)
A longer investment time horizon may make it easier for an investor to tolerate market fluctuations, but holding an investment longer does not make a risky investment risk-free. (supported)
Knowledge check
Test what you just learned.
Complete this short assessment for Investment Risk. You will get explanations immediately after grading.
Reference library