Investment Risk
The probability that an investment's actual return will differ from — or fall short of — its expected return.
What is Investment Risk?
Investment risk is the likelihood that an investment will generate a return that differs from what was expected, including the possibility of losing some or all of the invested principal. Risk in finance is measured by the variability of returns: higher variability equals higher risk. Investment risk encompasses multiple distinct types: market risk (systematic, driven by broad economic forces and undiversifiable), credit risk (default by a bond issuer), liquidity risk (inability to sell at a fair price), inflation risk (real return erosion), interest rate risk (bond price sensitivity to rate changes), currency risk (FX fluctuations), political risk, and operational risk. The fundamental risk-return trade-off holds that higher potential returns require accepting higher risk. Portfolio theory, developed by Harry Markowitz, shows that diversification can reduce total risk without proportionally reducing expected return by combining assets with low correlations.
Example
An investor comparing a 10-year Treasury bond yielding 4% versus a high-yield corporate bond yielding 8% faces a clear risk-return trade-off. The higher yield of the corporate bond compensates for greater credit risk (probability of default), less liquidity, and higher volatility. Both instruments carry interest rate risk; both face inflation risk. The investor must decide how much incremental risk is worth the additional 4% yield.
Source: CFA Institute — Risk and Return