Risk, return, volatility and why prices change
- Define return and calculate it
- Explain volatility as a measure of how bumpy returns are
- Understand why higher expected return usually comes with higher risk
Return
Return is how much an investment gained or lost, usually as a percentage. If you buy at $100 and it is worth $110 a year later, plus a $2 dividend, your total return is ($110 − $100 + $2) ÷ $100 = 12%.
Always ask over what period a return was measured. 12% in a month and 12% in a decade are very different things.
Volatility
Volatility measures how much returns jump around. A stock that moves 3% on a typical day is more volatile than one that moves 0.5%. Analysts often summarise it as the standard deviation of returns, usually annualised.
Volatility is not the same as losing money, but it matters: a volatile investment can be far below what you paid exactly when you need to sell.
Drawdowns: the risk you feel
A drawdown is a fall from a previous high. If a portfolio grows to $12,000 and then drops to $9,000, the drawdown is 25%. Broad stock markets have seen drawdowns of 30% to 50% several times in the last century.
Losses need bigger gains to recover: after a 50% fall you need a 100% gain to get back to where you started.
Why risk and return are linked
Investors demand to be paid for accepting uncertainty. Assets that can fall a lot must usually offer higher expected returns, or nobody would buy them. That is the risk–return trade-off.
The trade-off works on average and over long periods. It is not a promise: taking more risk does not guarantee more return, it only makes a wider range of outcomes possible.
Investment A returns +8% every year. Investment B alternates +28% and −12%. Both average 8% a year, but after two years A has grown $1,000 to $1,166 while B has grown it to $1,126.
Volatility drags on compounded growth. Bumpier paths end lower even with the same simple average.
Key terms
- Return
- The gain or loss on an investment over a period, including any income, usually as a percentage.
- Total return
- Price change plus dividends or interest received.
- Volatility
- How much an investment’s returns vary; higher volatility means bigger swings.
- Standard deviation
- A statistic that measures how spread out returns are around their average.
- Drawdown
- The percentage fall from a previous peak to a later low.
- Risk–return trade-off
- The tendency for assets with higher expected returns to carry higher risk.
In Market Explorer, look up a stock and SPY over the same five years. Compare their volatility and maximum drawdown numbers.
Key takeaways
- Measure returns over a stated period and include income.
- Volatility describes how bumpy the ride is.
- Drawdowns show the pain; big losses need even bigger gains to recover.
- Higher expected return comes with higher risk, not with certainty.