Risk, return, liquidity and time horizon

In simple terms

Four ideas sit under every investment decision.

• Return is what an investment earns: interest, dividends, rent, or a rise in its price, usually written as a percentage per year.
• Risk is the chance that what you actually get is different from what you expected. That includes earning less than hoped, and losing part or all of the money.
• Liquidity is how quickly you can turn an investment into cash without accepting a lower price.
• Time horizon is how long until you need the money.

They are linked. Investments that offer higher returns usually carry more risk, are less liquid, or both. And whether a risk is acceptable depends on your time horizon.

Why higher returns come with higher risk

Suppose two investments both expect to earn 7% a year, but one is certain to deliver it and the other might earn anything from −20% to +30%. Almost everyone prefers the certain one. For anyone to put money into the uncertain one, it has to offer a higher expected return. That extra return, paid for accepting uncertainty, is the main reason shares are expected to earn more than bank deposits over long periods. Because it is a reward for uncertainty, it is not guaranteed in any particular year, or even in any particular decade.

The reverse is not true: high risk does not create high returns by itself. Plenty of risky bets are simply bad bets. And an offer of high returns with little or no risk should make you suspicious, because if it existed, everyone would take it and the extra return would disappear. That is the logic behind the stock market scams lesson.

Liquidity

Liquid investments can be sold quickly at close to their current price. Shares of large listed companies are usually very liquid during market hours; a flat or a plot of land may take months to sell, and selling quickly often means accepting a lower price. A fixed deposit sits in between: you can usually break it early, but you may give up some interest.

Illiquidity has a cost, so less liquid investments often have to offer more to attract buyers. Before investing, ask two questions: how quickly could I get this money back, and what would it cost me to do so in a hurry? The bid-ask spread and liquidity lesson shows how liquidity appears in share prices.

Time horizon

Prices of shares and other risky investments can fall a long way in a short time. A fall of 30% needs a gain of about 43% just to get back to where you started, and that can take years. The bull and bear markets lesson works through the arithmetic.

So the time horizon matters:

A long horizon gives a fall more time to recover, which is why long-term money can carry more short-term risk. It does not make risk disappear. Some investments never recover, and markets can stay low for many years.

Why it matters

Almost every bad investment decision breaks one of these ideas: chasing a high return without asking about the risk, putting money needed next year into something that can halve, or buying something that cannot easily be sold. Thinking in these four terms before any decision is a habit that protects you, whatever you go on to invest in.

Limitations

• "Risk" is used here broadly. Later lessons measure it more precisely, for example as volatility or the largest fall from a peak, and each measure captures only part of it.
• The relationship between risk and return describes what markets tend to offer on average over long periods. It is not a rule that holds every year.
• The table is a general guide. Your own situation, such as job security and family responsibilities, changes how much risk you can carry.

Common mistakes

• Judging an investment only by its return. The question is always "what return, for what risk, and how easily can I get out?"
• Treating past returns as a guide to safety. A share that rose 60% last year can fall 40% next year.
• Mismatching money and horizon. Money for next year's fees or a wedding has no time to recover from a fall.
• Ignoring liquidity until you need cash. The time you need to sell is often the time prices are worst.

Try it yourself

1. List three places your household keeps money, such as a savings account, a gold chain or a mutual fund.
2. For each, write down roughly what it earns, how much its value could fall in a bad year, and how quickly you could turn it into cash.
3. Note when you are likely to need each of those sums. Do any of them carry more risk than their time horizon allows?