How to Evaluate Potential Gains, Prepare for Possible Losses, and Choose Investments That Fit Your Life
By the end of this lesson, you’ll understand:
Investing always involves uncertainty.
You may earn more than you expected.
You may earn less.
You may lose part or all of the money invested.
This uncertainty is not a defect in the investing system. It is one of the main reasons investments offer the possibility of earning a return.
If an investment promised high returns with no meaningful possibility of loss, nearly everyone would want it. Demand would rise, its price would change, and the unusually attractive opportunity would probably disappear.
That is why investment decisions cannot be based only on questions such as:
A more responsible question is:
Understanding risk does not mean avoiding every investment that can decline.
It means taking risks deliberately, for appropriate goals, in amounts you can financially and emotionally handle.
Investment risk is the uncertainty surrounding an investment’s future results and the possibility of financial loss.
Investor.gov defines risk as the degree of uncertainty and potential financial loss involved in an investment decision. It also explains that investors generally seek higher potential returns as investment risk increases. Investor.gov provides a current introduction to investment risk.
Risk can take many forms.
You may face the risk that:
Risk is not one number.
It is a collection of ways your actual result may differ from what you hoped or expected.
Investment return measures how much an investment gains or loses during a period.
Return may come from:
Return can be positive or negative.
Suppose you invest $1,000.
After one year:
Your total gain is:
$60 of price appreciation + $30 of dividends = $90
Your total return before taxes and fees is:
$90 ÷ $1,000 = 9%
Now suppose the investment falls to $900 and pays a $30 dividend.
Your total result is:
Negative $100 price movement + $30 dividend = negative $70
Your total return is:
Negative $70 ÷ $1,000 = negative 7%
Income does not automatically produce a positive total return.
A simplified total-return formula is:
Written another way:
Suppose:
The calculation is:
($5,300 − $5,000 + $100) ÷ $5,000
$400 ÷ $5,000 = 8%
This calculation does not yet account for:
Portfolio reports may use more advanced calculations when money enters or leaves the account during the measurement period.
An expected return is an estimate of what an investment or portfolio might earn based on assumptions, historical information, valuation, income, and other factors.
It is not a guaranteed future result.
Suppose a financial plan assumes that a portfolio will average 6% per year.
Actual annual returns might look like:
The investor does not receive a smooth 6% payment each year.
Even if the long-term average eventually approaches the assumption, the path may include major gains, losses, and long periods of disappointing performance.
A planning assumption is useful for estimating possible outcomes.
It should never be presented as a promised rate of return.
Investors generally expect to be compensated for accepting uncertainty.
For example, someone may be willing to hold a volatile stock because it offers greater growth potential than an insured savings account.
A lender may accept the possibility that a company could default because the company’s bond offers a higher yield than a lower-risk government security.
This additional expected compensation is sometimes called a risk premium.
The relationship can be summarized as:
The word “potential” is essential.
Taking more risk does not guarantee a higher return.
It only creates a wider range of possible outcomes.
A speculative investment may:
Greater risk creates the possibility of greater reward, not a promise of it.
Imagine two investments.
Investment B has the higher expected return.
It also has far more uncertainty.
An investor choosing Investment B must be prepared for the possibility that the expected return does not occur, especially over a short period.
The investor is not paid simply for choosing the riskier investment.
The higher expected return is compensation for accepting outcomes that may be painful or permanently damaging.
Volatility describes how much and how quickly an investment’s price moves.
A volatile investment may rise and fall substantially over short periods.
For example, an investment might move:
Volatility can be emotionally difficult, but a temporary price decline is not automatically a permanent loss.
A permanent loss may occur when:
A diversified market fund declining during a recession is different from one company collapsing because its business failed.
Both involve risk, but the nature of the risk is different.
A gain or loss is generally unrealized while you continue to own the investment.
Suppose you buy an investment for $1,000 and it declines to $800.
You have an unrealized loss of $200.
The value can continue changing.
A gain or loss generally becomes realized when you sell.
If you sell the investment for $800, the $200 loss becomes realized.
That distinction matters, but it can also be misunderstood.
An unrealized loss is still a real decline in your current wealth.
You should not ignore a deteriorating investment merely because you have not sold it.
At the same time, selling a sound long-term investment during a temporary decline can turn a recoverable market loss into a permanent financial result.
The investment’s quality, your reason for owning it, and your financial needs matter more than the label “realized” or “unrealized.”
Different investments expose you to different risks.
Understanding the name of the risk is less important than understanding how it can affect your money.
Market risk is the possibility that broad investment markets will decline.
Prices may fall because of:
Diversification can reduce dependence on one investment.
It cannot eliminate the possibility that an entire market or several asset classes decline together.
Business risk is the possibility that a company performs poorly.
A business may lose value because of:
Owning one company creates more business-specific risk than owning a broadly diversified group of companies.
Concentration risk occurs when too much of your financial future depends on one investment, company, industry, country, or strategy.
You may be concentrated without realizing it.
For example, you might:
If the employer struggles, you could lose income and investment value at the same time.
Several funds can also create concentration when they own many of the same securities.
The number of accounts or funds does not automatically determine diversification.
Credit risk is the possibility that a borrower or bond issuer cannot make promised payments.
An issuer may:
A higher bond yield may reflect a higher possibility of default.
Credit ratings can provide information, but they are opinions rather than guarantees.
Interest-rate risk is the possibility that changing market rates will affect an investment’s value.
Fixed-rate bond prices generally fall when market interest rates rise.
Suppose you own a bond paying 3%.
If newly issued bonds of similar quality begin paying 5%, your older bond becomes less attractive. Its market price may decline.
Longer-term bonds are generally more sensitive to changing interest rates than shorter-term bonds, all else being equal.
Interest rates can also affect:
Interest-rate risk is not limited to bonds.
Inflation risk is the possibility that rising prices reduce what your money can purchase.
Suppose you earn 3% while prices rise by 4%.
Your account balance grows, but your purchasing power may decline.
Investor.gov explains that inflation reduces the purchasing power of fixed interest and principal payments. Investor.gov discusses inflation and other common bond-investment risks.
Cash and conservative fixed-income investments may appear stable in dollar terms while losing real value.
Avoiding all price volatility can create a different risk: failing to grow enough to support future expenses.
Liquidity measures how easily an investment can be converted into cash at a reasonable price.
Liquidity risk is the possibility that:
Publicly traded shares of a large company may be highly liquid.
Other investments may be much harder to sell, including certain:
A profitable investment on paper may not help with an urgent expense if you cannot access the money.
Currency risk affects investments connected to foreign currencies.
Suppose a foreign investment gains 8% in its local currency.
If that currency falls 10% relative to the U.S. dollar, the U.S. investor may still experience a loss after conversion.
Currency movement can increase or reduce returns.
International diversification introduces potential benefits, but it also adds additional sources of risk.
Governments can change:
Political instability or regulatory changes can affect entire industries, countries, and markets.
An investment that appears attractive under current rules may perform differently if those rules change.
Reinvestment risk is the possibility that future cash flows must be reinvested at a lower return.
Suppose a bond pays 6% and then matures.
If similar new bonds offer only 3%, you cannot continue earning the same income without accepting different or greater risks.
Reinvestment risk can also affect:
Some borrowers can repay debt earlier than expected.
A company may call a bond after interest rates fall.
Homeowners may refinance mortgages, causing mortgage-backed securities to receive principal earlier.
The investor gets money back but may have to reinvest it at a lower rate.
A high interest payment may not last as long as expected.
Fraud risk is the possibility that an investment opportunity is deceptive, misrepresented, or completely fabricated.
Common warning signs include:
The SEC identifies promises of high returns with little or no risk as a major investment-fraud warning sign. Investor.gov lists current red flags of investment fraud.
A legitimate investment should allow you to ask:
If the person promoting the investment cannot clearly explain the risk, do not assume the risk is absent.
Sometimes the investment is not the greatest danger.
The investor’s behavior is.
Behavioral risk includes:
A portfolio should be designed not only for what looks reasonable on paper.
It should be designed so the investor can realistically continue following it during difficult periods.
Sequence-of-returns risk refers to the order in which gains and losses occur.
This risk is especially important when an investor is withdrawing money.
Two portfolios can earn the same average return but produce very different outcomes if one experiences major losses near the beginning of retirement.
Consider two retirees who begin with identical balances and withdraw the same amount.
Retiree B must sell more shares at depressed prices to fund spending. Fewer shares remain available to participate in a recovery.
The order of returns matters less when someone is still contributing and more when someone is withdrawing.
This risk will be explored further in Retirement Course.
Nominal return is the percentage gain before accounting for inflation.
Suppose an investment earns 7%.
Its nominal return is 7%.
Real return reflects the effect of inflation.
A simplified estimate is:
If the investment earns 7% while inflation is 3%, the approximate real return is:
7% − 3% = 4%
The exact calculation is:
(1.07 ÷ 1.03) − 1 = approximately 3.88%
Investor.gov defines real return as the return remaining after accounting for taxes and inflation. Review Investor.gov’s investment glossary.
Purchasing power is often more important than the number displayed in the account.
Taxes can reduce the return you keep.
Suppose an investment produces $1,000 of taxable income.
If $240 is paid in federal, state, and local taxes, the investor keeps $760.
The after-tax result depends on:
Interest, ordinary dividends, qualified dividends, and capital gains may receive different tax treatment.
A high pre-tax return does not automatically produce the highest after-tax return.
Tax consequences matter, but taxes should be evaluated alongside investment quality, risk, cost, and financial goals.
Risk tolerance is often described as the amount of investment risk you are willing and able to accept.
Those are two different things.
FINRA explains that risk tolerance depends on factors such as investment objectives, time horizon, reliance on the invested funds, and personal comfort with losses. FINRA explains how to evaluate your risk tolerance.
Risk willingness describes how emotionally comfortable you are with uncertainty and losses.
Ask:
Someone may believe they are comfortable with risk during a strong market and discover otherwise after a substantial loss.
Risk capacity describes your financial ability to absorb a loss.
It can depend on:
A wealthy investor with dependable income may have a high capacity for loss even if they dislike volatility.
A young investor may feel fearless but have low risk capacity if they need the money for tuition next year.
Risk need describes how much investment growth may be required to achieve the goal.
Suppose an investor already has enough money to comfortably fund retirement using a conservative portfolio.
That investor may have the capacity to accept substantial risk but little need to do so.
Another investor may believe they need extremely high returns because they have saved too little.
That does not make excessive risk appropriate.
When a goal requires unrealistic returns, the safer response may involve:
Taking unreasonable risk is not a dependable substitute for planning.
Your time horizon is the amount of time before you expect to need the money.
A longer horizon may provide more opportunity to recover from market declines.
A shorter horizon provides less recovery time.
Money needed in:
should not automatically be invested the same way.
Investor.gov explains that asset allocation should reflect both an investor’s time horizon and ability to tolerate risk. Investor.gov provides guidance on asset allocation, diversification, and time horizon.
Time does not guarantee recovery.
Individual companies, industries, or markets can suffer permanent losses.
A longer timeframe may improve your ability to tolerate diversified market volatility, but it does not transform a poor investment into a good one.
One person may have several portfolios with different purposes.
For example:
Risk should be connected to the specific goal.
A single risk label for your entire financial life may be too simplistic.
She expects to buy a home in two years.
She has saved $40,000 and cannot afford a major decline because she will need most of the money at closing.
Maya is personally comfortable with stock-market volatility, but her risk capacity for this goal is low.
She keeps the down-payment money in appropriately protected cash and short-term savings products.
The return may be modest, but preserving access to the money matters more than pursuing maximum growth.
Maya also contributes $500 per month to a retirement account.
She does not expect to use this money for approximately 30 years.
Her retirement portfolio includes diversified stock and bond funds.
During a difficult year, the portfolio declines by 18%.
Maya feels uncomfortable, but she reviews:
She continues contributing and plans to rebalance according to her established policy.
Maya does not use the same investment strategy for both goals.
She recognizes that risk is not determined only by personality.
It is determined by what the money must accomplish and when it will be needed.
Different investment categories tend to involve different combinations of risk and potential return.
Potential benefits:
Potential risks:
Potential benefits:
Potential risks:
Potential benefits:
Potential risks:
Potential benefits:
Potential risks:
No category is always best.
The appropriate combination depends on the investor and the goal.
The investment with the highest return was not necessarily the best decision.
Suppose:
Investment B earned more during the period.
That does not automatically mean it was the better investment.
A complete evaluation should consider:
Return should be judged relative to the risk required to pursue it.
Before purchasing an investment, ask:
Then go further:
When buying ordinary shares with cash in a standard brokerage account, the loss is generally limited to the amount invested.
Borrowing on margin, using certain options, selling short, or applying leverage can create larger or more complicated losses.
Never assume the maximum loss is obvious.
Diversification spreads money among different investments.
It can reduce the damage caused by:
Diversification cannot guarantee against loss.
It may not prevent a portfolio from declining during a broad market downturn.
Investor.gov describes diversification as spreading money among different investments to reduce risk rather than depending on one basket. Investor.gov explains diversification and asset allocation.
The next lesson will explore diversification in detail.
What must this money accomplish?
When will you need the money?
How far could the investment reasonably decline?
Could it become worthless?
Would a loss affect:
Would you abandon the plan during a decline?
How does it produce a return?
What could prevent that return?
How much of your portfolio, income, or future depends on the same company, industry, or economic outcome?
Can you access the money when needed?
What price might you receive?
Consider:
Ask:
If you cannot explain the risk, you are not ready to evaluate the return.
Financial confidence does not come from believing nothing will go wrong.
It comes from building a plan that can remain useful when something does.
Meet Maya.
Maya is 35 and has two financial goals.
Promotional material often emphasizes the best possible result.
Always investigate the possible loss.
Strong historical returns do not guarantee strong future returns.
A recently successful investment may now be expensive, crowded, or vulnerable.
An investment with a stable displayed price can still carry credit, inflation, liquidity, or fraud risk.
Falling behind on a goal can create pressure to pursue unrealistic returns.
A large loss can make the shortfall worse.
It is easy to describe yourself as aggressive when prices are rising.
Your behavior during a real decline provides better evidence.
Preserving the number of dollars is not the same as preserving purchasing power.
Money needed next year should not automatically carry the same risk as retirement money needed in 30 years.
Diversification reduces certain risks.
It does not remove market risk or guarantee a positive return.
Higher risk guarantees a higher return.
Higher risk creates the potential for higher returns and larger losses. The expected reward may never occur.
Cash has no risk.
Cash may be stable in dollar terms but can lose purchasing power to inflation and miss potential investment growth.
A temporary decline is always harmless.
Some investments recover, while others remain impaired or become worthless. Your need to sell can also turn a temporary decline into a permanent result.
If I have a long time horizon, I can invest in anything.
Time may help manage diversified market volatility, but it does not eliminate fraud, concentration, excessive fees, or business failure.
An investment paying income is safer than one that does not.
Dividends, interest, and distributions can be reduced or outweighed by price losses.
My risk tolerance is determined by my age.
Age may affect time horizon, but goals, income stability, dependents, liquidity needs, emotional comfort, and other resources also matter.
Diversification prevents my portfolio from declining.
Diversification can reduce investment-specific risk, but diversified portfolios can still experience broad market losses.
A guaranteed high return is the safest opportunity.
Promises of unusually high returns with little or no risk are classic warning signs of fraud.
There is no universal good return.
A return must be evaluated relative to:
A stable 4% return may be appropriate for one purpose, while an uncertain 8% return may be appropriate for another.
Take only the amount of risk that fits your goal, timeframe, financial capacity, and ability to continue following the plan.
You do not need to accept every risk you can financially survive.
Stocks are generally more volatile than high-quality bonds, but categories overlap.
A speculative, low-quality bond can carry greater default risk than shares of a financially strong company. Each investment must be evaluated individually.
No.
A longer horizon provides more time to recover from certain market declines. It does not guarantee recovery or eliminate company-specific, fraud, liquidity, or concentration risk.
No.
Volatility creates uncertainty and can be emotionally difficult, but long-term investors may accept it in pursuit of growth.
Volatility becomes especially dangerous when it causes you to sell, when you need the money soon, or when it reflects permanent deterioration.
Some ETFs are broadly diversified, while others are concentrated, leveraged, inverse, or connected to highly speculative assets.
An ETF can experience substantial losses. The fund label alone does not determine safety.
Investors are generally willing to accept lower returns when an investment provides greater stability, liquidity, or confidence in repayment.
Higher-risk issuers or strategies may need to offer greater potential compensation to attract investors.
Consider how you responded during previous declines.
If you have never experienced a substantial loss, use hypothetical scenarios:
Your risk tolerance should reflect both your emotional response and your financial ability to absorb loss.
Not automatically.
Past performance does not guarantee future results. Review the investment’s risks, valuation, diversification, costs, strategy, and role in your plan.
No.
A professional may assist with research, portfolio construction, and discipline, but no adviser or manager can eliminate market uncertainty or guarantee investment success.
Do not invest until you understand:
Complexity is not proof of sophistication.
If the risk cannot be explained clearly, stepping away may be the most informed decision.
Complete a risk-and-return review for one investment you currently own or are considering.
Write down:
The investment’s purpose
Your time horizon
How it may produce a return
Its possible income
Its major risks
A reasonable severe-loss scenario
Whether it could become worthless
How easily it can be sold
Its fees and likely tax treatment
The percentage of your portfolio it would represent
Then answer:
If this investment experienced the loss I described, could I still meet the goal, and would I realistically continue following my plan?
If the answer is no, the investment or position size may involve more risk than your plan can support.
Understanding risk is the beginning.
Managing risk also means managing your own reaction to it, especially when the market moves sharply. The next lesson explains why market declines feel worse than they are, and how to avoid reacting in ways that work against your own plan.
In the next lesson, you will learn:
Managing your own behavior is one of the most overlooked parts of successful investing.
Explore More LessonsLet us know if this lesson was useful, it helps us know what to keep improving.
Thanks for letting us know!