Risk and return: volatility, drawdowns and the equity premium

Every investment offers some mix of two things: the return you hope to earn and the risk that you won't. They are tied together. Assets that have offered higher long-run returns, such as stocks, have also delivered bigger and more frequent losses along the way. Assets that rarely lose much, such as short-term government bonds and insured savings, have tended to pay less.

This guide explains what "risk" actually means to an investor, the two numbers most people use to measure it (volatility and drawdown), why markets pay a premium for holding risky assets, and what five years of real data on a stock fund and a bond fund show about the tradeoff, including a period when the "safe" asset lost money too.

What risk means to an investor

In everyday speech, risk means the chance of something bad happening. In investing it is more specific: the chance that your actual result differs from what you expected, especially on the downside. Several kinds matter:

• Market risk: the whole market falls, and almost everything falls with it.
• Company risk: one business disappoints or fails. Diversification reduces it.
• Interest-rate risk: when rates rise, existing bonds lose value. This hit bond investors hard in 2022.
• Inflation risk: your money grows, but prices grow faster.
• Liquidity risk: you can't sell quickly at a fair price.
• Sequence risk: a large loss arrives just before you need the money.

The last one is why the same investment can be low-risk for one person and high-risk for another. A 30% fall is painful but survivable for someone who won't touch the money for 20 years. It can be disastrous for someone who needs it next year.

Measuring return

A return is the percentage change in value over a period, including income. For a stock or fund:

Over many years, returns are usually expressed as a compound annual growth rate (CAGR), the steady yearly rate that links the start and end values. The Compound interest: how growth on growth builds wealth guide shows how it is calculated and why it is lower than the simple average whenever returns vary.

Measuring risk: volatility

Volatility is the standard deviation of returns: a measure of how far typical returns land from their average. It is usually quoted on an annual basis. If weekly returns have a standard deviation of 2.25%, the annualized figure is about 2.25% × √52 ≈ 16.2%.

A rough way to read it: in about two years out of three, an asset's annual return lands within one volatility of its average. An asset that averages 8% with 16% volatility might return anywhere from −8% to +24% in a typical year, and much more or less in an unusual one.

Volatility is convenient, but it treats upside surprises the same as downside ones and assumes swings are roughly symmetrical. Real markets have fatter tails: rare, very large moves happen more often than the normal bell curve predicts.

Measuring risk: drawdown

Drawdown is the decline from a previous high to a later low. The maximum drawdown over a period is the largest of those declines. It answers the question most investors actually care about: "What is the most I would have lost, on paper, if I had bought at the worst moment?"

Drawdown also connects directly to recovery. A 25% decline needs a 33% gain to get back to even, and a 50% decline needs 100%. The time spent under water, the recovery period, can be longer than the fall itself.

Five years of stocks and bonds, on real data

The chart compares two widely held funds over the same five years in Finabase's data: SPY, which holds the 500 large US companies in the S&P 500, and AGG, which holds a broad mix of US investment-grade bonds.

• SPY went from $459.25 to $769.36, about 10.8% a year in price alone. Its weekly returns had an annualized volatility of about 16.3%. Its maximum drawdown on weekly closes was 24.8%, from the week of December 27, 2021 to the week of September 26, 2022.
• AGG went from $114.64 to $96.15, about −3.4% a year in price. Its volatility was only 5.8%, about a third of SPY's. Yet its maximum price drawdown was 20.2%, from November 2021 to October 2023, as interest rates rose quickly and existing bonds were marked down.

Two lessons come out of this. First, volatility and drawdown can tell different stories. AGG was far calmer week to week, but a slow, steady decline still added up to a drawdown comparable to SPY's. Second, the price-only view is unfair to bonds: a bond fund's return comes mostly from the interest it pays, which this chart leaves out. Including interest, AGG's loss over the period was much smaller than its price decline suggests. Even so, 2022 was a rare year when both stocks and bonds fell together, a reminder that "safe" is relative.

Why risk and return go together

Imagine two investments that cost the same and promise the same average return, but one is far more volatile. Rational investors would sell the volatile one and buy the steady one until the volatile one's price fell enough to offer a higher expected return. Prices adjust until the riskier asset compensates investors for the extra uncertainty.

The extra return investors expect for owning stocks instead of risk-free government securities is called the equity risk premium. It cannot be observed directly in advance. It is estimated from history or from current prices, and the estimates vary with the method and period. What matters for a beginner is the principle: the premium is expected, not guaranteed. Over short and even medium periods, stocks can and do return less than safe assets.

The relationship also runs only one way. Higher risk is necessary for higher expected returns, but it is not sufficient. Concentrating in a single speculative stock adds a lot of risk that markets do not pay you for, because you could have diversified it away for free.

The risk ladder

The ladder is a generalization. In any given year an asset can behave very differently from its usual profile, as bonds did in 2022.

Managing risk without avoiding it

Diversify. Owning many companies across sectors and countries removes most company-specific risk at little cost. It does not remove market risk.

Mix asset classes. Combining stocks with bonds and cash lowers the volatility and drawdowns of the whole portfolio, at the cost of some expected return. The mix is usually called asset allocation.

Match the horizon. Money needed within a few years generally belongs in low-volatility assets. Money for goals decades away can usually tolerate more.

Size positions. No single holding should be able to do serious damage to your plan.

Decide in advance. Write down how much of a decline you could sit through without selling. If the honest answer is 10%, a portfolio that can fall 50% is too risky for you, whatever its average return.

Common misconceptions about risk

• "Low volatility means safe." A steady asset can still lose real value to inflation, or decline slowly for years.
• "Past volatility predicts future risk." It's a guide, not a guarantee. Calm periods often precede turbulent ones.
• "More risk always means more return." Only risk that can't be diversified away is rewarded on average.
• "A loss isn't real until you sell." On paper that's true, but if you are forced to sell, or can't stand to hold, the loss becomes permanent.

How Finabase helps

Each symbol page shows a fund's or stock's price history on an interactive chart, so you can see its past drawdowns for yourself, along with key statistics. The comparison page puts several symbols on a chart rebased to the same start, the same view as the figure above, so you can compare, say, a stock fund and a bond fund over any period. The Treasury page shows current US government yields, the "risk-free" baseline against which other returns are judged.

Frequently asked questions

What is the risk-return tradeoff?

It is the principle that assets with higher expected returns come with more uncertainty, including larger potential losses. Investors accept that uncertainty only if they expect to be paid for it.

What is a good measure of investment risk?

There is no single best measure. Volatility shows how much returns swing; maximum drawdown shows the worst fall from a peak. Looking at both, along with how long recovery took, gives a fuller picture than either alone.

Can bonds lose money?

Yes. Bond prices fall when interest rates rise, and a bond issuer can default. From November 2021 to October 2023 the price of the broad bond ETF AGG fell about 20% in Finabase's data, although its interest payments offset part of that.

What is the equity risk premium?

It is the extra return investors expect from stocks over risk-free government securities as compensation for stocks' greater risk. It is an expectation, estimated rather than observed, and stocks can underperform safe assets for long stretches.

Summary

Return and risk are two sides of the same choice. Volatility measures how much returns swing; drawdown measures how far an investment can fall from its high and how deep a hole has to be climbed out of. Markets pay a premium, on average, for bearing risk that can't be diversified away, which is why stocks have historically outpaced bonds over long periods despite sharp declines. Five years of SPY and AGG data show both the reward and the cost, and a reminder that even low-volatility assets can lose. The right amount of risk is the amount your goals require and your time horizon and temperament can carry.