<< Chapter < Page Chapter >> Page >

The tradeoffs between return and risk

The discussion of financial investments has emphasized the expected rate of return, the risk, and the liquidity of each investment. [link] summarizes these characteristics.

Key characteristics for financial investments
Financial Investment Return Risk Liquidity
Checking account Very low Very little Very high
Savings account Low Very little High
Certificate of deposit Low to medium Very little Medium
Stocks High Medium to high Medium
Bonds Medium Low to medium Medium
Mutual funds Medium to high Medium to high Medium to high
Housing Medium Medium Low
Gold Medium High Low
Collectibles Low to medium High Low

The household investment choices listed here display a tradeoff between the expected return and the degree of risk involved. Bank accounts have very low risk and very low returns; bonds have higher risk but higher returns; and stocks are riskiest of all but have the potential for still higher returns. In effect, the higher average return compensates for the higher degree of risk. If risky assets like stocks did not also offer a higher average return, then few investors would want them.

This tradeoff between return and risk complicates the task of any financial investor: Is it better to invest safely or to take a risk and go for the high return? Ultimately, choices about risk and return will be based on personal preferences. However, it is often useful to examine risk and return in the context of different time frames.

The high returns of stock market investments refer to a high average return that can be expected over a period of several years or decades. The high risk of such investments refers to the fact that in shorter time frames, from months to a few years, the rate of return may fluctuate a great deal. Thus, a person near retirement age, who already owns a house, may prefer reduced risk and certainty about retirement income. For young workers, just starting to make a reasonably profitable living, it may make sense to put most of their savings for retirement in stocks. Stocks are risky in the short term, to be sure, but when the worker can look forward to several decades during which stock market ups and downs can even out, stocks will typically pay a much higher return over that extended period than will bonds or bank accounts. Thus, tradeoffs between risk and return must be considered in the context of where the investor is in life.

Key concepts and summary

All investments can be categorized according to three key characteristics: average expected return, degree of risk, and liquidity. To get a higher rate of return, an investor must typically accept either more risk or less liquidity. Banks are an example of a financial intermediary, an institution that operates to coordinate supply and demand in the financial capital market. Banks offer a range of accounts, including checking accounts, savings accounts, and certificates of deposit. Under the federal deposit insurance program, banks purchase insurance against the risk of a bank failure.

A typical bond promises the financial investor a series of payments over time, based on the interest rate at the time the bond is issued, and then repayment of what was borrowed. Bonds that offer a high rate of return but also a relatively high chance of defaulting on the payments are called high yield or junk bonds. The bond yield is the rate of return that a bond promises to pay at the time of purchase. Even when bonds make payments based on a fixed rate of interest, they are somewhat risky, because if interest rates rise for the economy as a whole, an investor who owns bonds issued at lower interest rates is now locked into the low rate and suffers a loss.

Changes in the price of a stock depend on changes in expectations about future profits. Investing in any individual firm is somewhat risky, so investors are wise to practice diversification, which means investing in a range of companies. A mutual fund purchases an array of stocks and/or bonds. An investor in the mutual fund then receives a return depending on the overall performance of the investments made by the fund as a whole. A mutual fund that seeks to imitate the overall behavior of the stock market is called an index fund.

Housing and other tangible assets can also be regarded as forms of financial investment, which pay a rate of return in the form of capital gains. Housing can also offer a nonfinancial return—specifically, you can live in it.


Imagine that a $10,000 ten-year bond was issued at an interest rate of 6%. You are thinking about buying this bond one year before the end of the ten years, but interest rates are now 9%.

  1. Given the change in interest rates, would you expect to pay more or less than $10,000 for the bond?
  2. Calculate what you would actually be willing to pay for this bond.

Got questions? Get instant answers now!

Suppose Ford Motor Company issues a five year bond with a face value of $5,000 that pays an annual coupon payment of $150.

  1. What is the interest rate Ford is paying on the borrowed funds?
  2. Suppose the market interest rate rises from 3% to 4% a year after Ford issues the bonds. Will the value of the bond increase or decrease?

Got questions? Get instant answers now!


Howley, Kathleen M. Bloomberg. “Home Value Highest Since ’07 as U.S. Houses Make Cash.” Last modified March 26, 2013. http://www.bloomberg.com/news/2013-03-26/home-value-highest-since-07-as-u-s-houses-make-cash-mortgages.html.

NASDAQ.com. 2015. “Facebook, Inc. Historical Stock Prices.” Accessed March 28, 2015. http://www.nasdaq.com/symbol/fb/historical.

National Association of Realtors. 2015. “Existing-Home Sales: Latest News.” Accessed April 1, 2015. http://www.realtor.org/topics/existing-home-sales/data.

PricewaterhouseCoopers LLP. 2015. “Annual Venture Capital Investment Tops $48 Billion in 2014, Reaching Hightest Level in Over a Decade, According to the Moneytree Report.” Accessed April 1, 2015. http://www.pwc.com/us/en/press-releases/2015/annual-venture-capital-investment-tops-48-billion.jhtml.

Rooney, Ben. “Trading Program Sparked May ‘Flash Crash’.” CNN Money . Last modified October 1, 2010. http://money.cnn.com/2010/10/01/markets/SEC_CFTC_flash_crash/index.htm.

Investment Company Institute. “2013 Investment Company Fact Book, Chapter 6: Characteristics of Mutual Fund Owners.” http://icifactbook.org/fb_ch6.html.

Questions & Answers

Method of distribution
Emma Reply
Am nuhu from Ghana and u?
Am nuhu from Ghana and u?
what's your objective to learning economics
am Nuhu from Ghana and u?
To become an Economist
nice meeting u guyz
we can all meet when we come up on difficulties to resolve them
yeah !
hi guys
@Paramount OO i leave in south africa
we can me more chat
hey guys
what's upp?
How is everyone here? it is King Wobokolo saying hi from Uganda
juxtapose indisputable fact of scarcity
Adebayo Reply
what is opportunity cost?
Opportunity cost is the want sacrificed to satisfy another want.
opportunity cost is a forgone alternative, example if a consumer wants to buy a book Nd a pen but he does not have the money for both then he drops the pen Nd buys the book..... so the pen that he dropped Is the opportunity cost
opportunity cost is the alternative forgone or goods that is left on satisfied in order to satify another want
it is also the satisfaction of a want with the expense of another want
what is surplus value theory
what does the law demand and supply states
the law of demand state that at a higher price less is demanded and at low price more is demanded
the law supply state that at a higher price more is demanded and at a low price less is demanded
THE LAW OF DEMAND states that, All other things being equal, at a higher price, consumers demand less and at a lower price more is demanded. THE LAW OF SUPPLY states that, All other things being equal, producers produce more quantity at a higher price and less at a lower price.
what is the law of diminishing returns?
the of diminishing returns state that the continues addition of fixed to a variable factor of production may lead to an increase in marginal production but at a point in time marginal production may diminished or falls
what is the equilibrium quantity
Zinna Reply
differentiate between equilibrium and equilibrium point
Leo Robinson's definition
Adejimi Reply
how is equilibrium defined in financial markets?
Babakura Reply
the concept of it
Country A has export sales 20 billion, government purchases 1000billion, business investment is 50 billion, imports are 40billion, and consumption spending is 2000billin. What is the dollar value of GDP ?
Habtamu Reply
What are the method of distribution
what is determination of national income?
Waqar Reply
economic growth
stock of capital
we're RBI keep money with them
Y =C+l
evaluate the success affirmative action as one of south Africa's redress method
Tebatso Reply
what is market equilibrium
explorer Reply
it is a situation in which the supply of an item is exactly equal to it dd .
inder wat condition shld a firm stop production in both short n lungrun ?
what is 2nd degree price discrimination?
what is quantity
what is quantity2
Deji Reply
An indefinite amount of something.
what is the opportunity cost of producing 20 loaves of bread?
what is demand
Kaman Reply
in ordinary sense demand means desire
demand in economics means both willingness as well as the ability to purchase a commodity by paying a price an also its actuall purchase
what is absolute advantage
demand refers to the various quantity of goods and services that consumers are willing and able to purchase at a particular period of time all other things been equal
The amount of a good or service that consumers are willing to buy at a particular price.
what is cost pull inflation?
what is utility
what is cost pull inflation?
demand is economic principle referring to a consumer's desire and willingness to pay a price for a specific or service..
utility is the among of certisfaction driving from using a comundity
pull cost of inflation hight population unemployment to some of The country members poor government system
what is a buffer scheme
state the second law of demand and supply
Ahmadou Reply
state the law of diminishing marginal utility
dt know WATS the answer
mention and explain two Bank I financial institutions and two non baking financial institutions
Onah Reply
wat is demand pull inflation
Tony Reply
Demand-pull inflation is asserted to arise when aggregate demandin an economy outpaces aggregate supply. It involvesinflation rising as real gross domestic product rises and unemployment falls, as the economy moves along the Phillips curve.
Perfectly elastic demand
Abubakar Reply
this is a form of demand where goods are demanded at a constant price
what inelastic demanding
demand of any good demanded more after a certain period. if a commodity prices may high and scarcity of that resources.
cannot demand more

Get the best Principles of economics course in your pocket!

Source:  OpenStax, Principles of economics. OpenStax CNX. Sep 19, 2014 Download for free at http://legacy.cnx.org/content/col11613/1.11
Google Play and the Google Play logo are trademarks of Google Inc.

Notification Switch

Would you like to follow the 'Principles of economics' conversation and receive update notifications?