The golden rule of investing
There's one fundamental principle in investing: higher potential returns come with higher risk. This isn't a flaw in the system — it's how financial markets reward investors for taking on uncertainty.
The investment risk spectrum
Different investments carry different levels of risk and potential return.
Low risk, low return
Historical annual return: roughly 1–3%
- Savings accounts (FDIC insured)
- CDs (certificates of deposit)
- Government bonds (Treasury bills)
- Money market funds
Moderate risk, moderate return
Historical annual return: roughly 4–7%
- Corporate bonds
- Balanced mutual funds
- REITs (real estate investment trusts)
- Target-date funds
Higher risk, higher return potential
Historical annual return: roughly 8–12%
- Stock market index funds
- Individual stocks
- International and emerging market funds
- Growth-focused investments
These ranges describe what these asset classes have delivered historically. They are not guarantees, and any given year can look very different.
Types of investment risk
Understanding the different types of risk helps you make informed decisions.
Company risk
The risk that a specific company performs poorly.
Solution: diversify across many companies
Sector risk
The risk that an entire industry struggles.
Solution: invest across different sectors
Market risk
The risk that the entire market declines.
Solution: long-term investing and asset allocation
Inflation risk
The risk that inflation erodes purchasing power.
Solution: invest in assets that have historically beaten inflation
Historical risk and return data
Here's how different asset classes have performed historically (1926–2020):
| Asset class | Average return | Worst year | Best year |
|---|---|---|---|
| Large-cap stocks | 10.5% | -43.1% (2008) | +54.0% (1935) |
| Small-cap stocks | 12.1% | -58.0% (1937) | +142.9% (1933) |
| Corporate bonds | 6.3% | -8.1% (2008) | +42.6% (1982) |
| Treasury bills | 3.3% | 0.0% (1940s) | +14.7% (1981) |
Time horizon and risk
Your investment timeline dramatically affects how much risk you can afford to take.
Short-term (1-3 years)
Risk tolerance: very low — you need your money soon and can't afford losses.
Typically suited to: high-yield savings, CDs, short-term bonds
Medium-term (3-10 years)
Risk tolerance: moderate — some volatility is acceptable.
Typically suited to: balanced funds, a conservative stock and bond mix
Long-term (10+ years)
Risk tolerance: higher — there is time to recover from market downturns.
Typically suited to: stock-heavy portfolios, index funds, growth investments
Risk tolerance quiz
Answer these questions to get a sense of your personal risk tolerance.
1. Your portfolio drops 20% in one month. You:
- A) Panic and sell everything
- B) Feel nervous but hold steady
- C) See it as a buying opportunity
2. You prefer investments that:
- A) Never lose money, even if returns are low
- B) Have moderate fluctuations for better returns
- C) Can be volatile but offer high long-term potential
3. When investing, your main goal is:
- A) Preserving your money
- B) Steady, predictable growth
- C) Maximum long-term wealth building
Managing risk through diversification
You can reduce risk without sacrificing much return through smart diversification.
Good diversification
- Total stock market index fund
- International stock exposure
- Some bond allocation
- REITs for real estate exposure
- Different company sizes
Poor diversification
- Only tech stocks
- Just your employer's stock
- Only US companies
- Single sector focus
- Just a few individual stocks
Our guide to portfolio diversification goes through this in more depth.
The cost of playing it too safe
While it's natural to want to avoid risk, being too conservative carries its own risks.
Practical risk management strategies
Start with your time horizon
The longer you can invest, the more risk you can afford to take.
Diversify broadly
Use index funds to spread risk across hundreds or thousands of investments.
Use dollar-cost averaging
Regular investing reduces the impact of market timing.
Stay disciplined
Don't let emotions drive your investment decisions.
Finding your risk-return sweet spot
Once you know how much risk you're comfortable with, you can test different return assumptions in the calculator and see how the range of outcomes changes.