Anyone who has invested in anything is familiar with the trade-off between risk and return whether you’ve consciously weighed the options and thought about it or not. Before you’ve bought into an investment, you’ve decided that you’re able to stomach the risk is hopes of certain returns. And in order to make long term financial progress you need to decide what level of risk you can handle while at the same time remaining comfortable with your investments.

Investment risk can be defined as the chance that an investment’s actual return will be different than expected. Risk also means that there is the possibility of losing some, if not all, or your investment. Where there are low levels of uncertainty, there are low potential returns. The opposite is true for high levels of uncertainty.

It is important however, to remember that higher risk does not equal higher returns. Higher risk only gives us the possibility for higher returns. There are also greater potential losses.

While we’re on this subject, I think it’s also important to bring up the concept of the risk premium. Too many try to balance their risk against the wrong return. If they’re going to take a risk in the stock market, they’re looking for a return of about %11 percent or so. Now, would you be willing to take the same risk for only 6%? Because this is what you’re doing essentially.

Take a look at U.S. Government bonds and what they are paying. Let’s say that they’re offering a 5% return. Because these types of bonds are virtually risk free, they represent a risk free rate of return. Mutual funds may have losses of -6% one year and gains of 20% the next for an average of around 11%. The difference between the 11% and the 5% is called the risk premium. The risk you take by investing in mutual funds is for the additional 6% return.

Not everyone goes through this type of analysis when they’re investing, but the concept is important to understand. You don’t want to take on a large amount of risk if there isn’t a significant risk premium.

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