Back to Investing & Retirement

A Beginner's Guide to Investment Returns and Risk

10 min read

A Beginner's Guide to Investment Returns and Risk

Every investor wants the same thing: to grow their money. But the gap between expectations and reality is where most beginners stumble. Some assume they'll double their money overnight, others are so afraid of losing anything that they leave everything in a savings account and watch inflation slowly erode it. Understanding how investment returns actually work -- and how risk fits into the picture -- is the foundation of every sound financial plan.

What Is an Investment Return?

An investment return is the money you earn (or lose) on an investment over a period of time. Returns come from two sources:

  • Capital gains: The increase in the price of your investment. If you buy a stock at $50 and it rises to $65, your capital gain is $15.
  • Income: Cash payments your investment generates while you hold it. For stocks, this is dividends. For bonds, it is interest payments. For real estate, it is rental income.

Your total return combines both components. A stock that rises 6% in price and pays a 2% dividend delivers an 8% total return for the year. Focusing on price alone -- the number you see flashing on a screen -- gives you an incomplete and often misleading picture.

Types of Returns

Not all return figures mean the same thing. Understanding the distinctions will save you from comparing apples to oranges.

Nominal vs. Real (Inflation-Adjusted) Returns

A nominal return is the raw percentage your investment gained. A real return subtracts inflation, showing your actual increase in purchasing power. If your portfolio returns 10% in a year when inflation is 3%, your real return is roughly 7%. Over long periods, the difference is enormous. An investment that compounds at 10% nominal for 30 years grows $10,000 to about $174,000. Adjust for 3% inflation, and the purchasing power of that sum is closer to $76,000 in today's dollars. Always think in real terms when planning for goals years or decades away.

Total Return vs. Price Return

Price return measures only the change in an asset's market price. Total return adds reinvested dividends or interest payments. The S&P 500's price return since 1926 averages roughly 7% per year, but its total return -- with dividends reinvested -- averages about 10%. That 3-percentage-point gap compounds into a massive difference over a lifetime. When you see return figures in the media, check whether they include dividends. If they don't, the numbers understate reality.

Annualized vs. Cumulative Returns

A cumulative return tells you how much an investment has gained in total over a period. If you invest $10,000 and it grows to $25,000 over 10 years, your cumulative return is 150%. An annualized return converts that into a consistent yearly rate, accounting for compounding. In this case, the annualized return is about 9.6% per year. Annualized returns are far more useful for comparing investments across different time periods.

Historical Returns by Asset Class

History does not guarantee the future, but it provides the best baseline we have. Here are long-term average annual returns for major asset classes in the United States:

| Asset Class | Nominal Return | Real Return (After Inflation) | |---|---|---| | US Stocks (S&P 500) | ~10% | ~7% | | Bonds (US Aggregate) | ~5% | ~2% | | Cash / Savings Accounts | ~3% | ~0% | | Real Estate | ~4-8% | ~1-5% |

A few things stand out. Stocks have delivered the highest returns over long horizons, but they come with the most turbulence along the way. Bonds provide steadier but more modest growth. Cash barely keeps up with inflation -- and in many recent years, it has not kept up at all. Real estate returns vary widely depending on whether you measure home price appreciation alone (lower end) or total returns including rental income and leverage (higher end).

The Risk-Return Tradeoff

There is no free pass to high returns without exposure to risk. This is the most fundamental law of investing, and it holds across every market and every era.

What Risk Actually Means

In investing, risk is not just the possibility of losing money. It is the uncertainty of outcomes -- the range of results you might experience in any given year. Two concepts capture this:

  • Volatility (standard deviation): A measure of how much returns swing above and below the average. The S&P 500 has a historical standard deviation of about 15-16%. This means in a typical year, returns might land anywhere from roughly -6% to +26% -- and in extreme years, far outside that range.
  • Maximum drawdown: The largest peak-to-trough decline an investment has experienced. The S&P 500 dropped approximately 57% during the 2007-2009 financial crisis. If you had $100,000 invested at the peak, it fell to about $43,000 at the trough before eventually recovering.

Why Higher Returns Require More Risk

If a safe, stable investment could deliver 10% annual returns, no one would ever buy stocks. The reason stocks offer higher long-term returns is precisely because investors demand compensation for enduring gut-wrenching declines. That extra return above what a risk-free asset pays is called the equity risk premium, and it exists because holding stocks through crashes, recessions, and panics is genuinely difficult. The premium is your reward for not panicking.

Diversification: The Only Free Lunch in Investing

Nobel laureate Harry Markowitz called diversification "the only free lunch in finance." The idea is simple but powerful: by combining assets that don't move in lockstep, you can reduce risk without necessarily sacrificing returns.

Asset Allocation Basics

Asset allocation is how you divide your portfolio among different asset classes -- stocks, bonds, cash, real estate, and others. A classic starting point is the 60/40 portfolio: 60% stocks, 40% bonds. Historically, this blend has captured a large share of stock market returns while significantly dampening volatility. Younger investors with decades ahead might allocate 80-90% to stocks. Those nearing retirement might shift closer to 40-50% stocks.

Correlation and Why Mixing Works

Correlation measures how closely two assets move together. When stocks plunge, high-quality bonds often rise or hold steady, cushioning your overall portfolio. Assets with low or negative correlation to each other are the most powerful diversifiers. This is why a portfolio of 80% stocks and 20% bonds has historically delivered nearly the same return as 100% stocks but with meaningfully lower volatility and smaller drawdowns.

Dollar-Cost Averaging: Smoothing Out Volatility

Dollar-cost averaging (DCA) means investing a fixed amount at regular intervals -- say, $500 every month -- regardless of market conditions. When prices are high, your fixed amount buys fewer shares. When prices drop, the same amount buys more shares. Over time, this naturally lowers your average cost per share.

DCA does not guarantee higher returns than investing a lump sum all at once. Statistically, lump-sum investing wins about two-thirds of the time because markets trend upward. But DCA has a different advantage: it removes the paralyzing fear of investing a large sum right before a downturn. For most people, especially beginners, the biggest risk is not investing at all. DCA gets money into the market consistently, which matters far more than timing.

The Power of Staying Invested

Market timing -- jumping in before rallies and out before crashes -- sounds appealing in theory. In practice, it is nearly impossible. Research from J.P. Morgan's Guide to the Markets shows that if you invested $10,000 in the S&P 500 from 2003 to 2022 and stayed fully invested, you would have ended with approximately $64,844 (an annualized return of about 9.8%). But if you missed just the 10 best days during that period, your ending balance would drop to around $29,708 -- less than half. Miss the 20 best days, and you'd have just $19,347.

The best days in the market often occur during or immediately after the worst days. Selling in a panic means you almost certainly miss the rebound. The data overwhelmingly supports a simple strategy: invest consistently, stay invested, and resist the urge to react to short-term noise.

Setting Realistic Expectations

Market Averages Include Terrible Years

The S&P 500's ~10% long-term average includes years like 2008 (-37%), 2002 (-22%), and 2022 (-18%). Averages are not normal years -- they are the smoothed result of wild swings in both directions. In any single year, the probability of earning exactly 10% is quite low. What matters is that over 10, 20, and 30-year periods, the average has been remarkably consistent for patient investors.

Sequence of Returns Risk Near Retirement

Earning -20% in your first year of retirement is far more damaging than earning -20% in year fifteen. This is called sequence of returns risk -- the order in which returns occur matters enormously when you are withdrawing money from your portfolio. A string of poor returns early in retirement depletes your balance faster, leaving less capital to recover when markets eventually rebound. This is the primary reason financial advisors recommend shifting toward more conservative allocations as you approach retirement.

Common Beginner Mistakes

Timing the market. Study after study shows that even professional fund managers cannot consistently predict short-term market movements. If the experts can't do it, individual investors relying on gut feelings or news headlines have virtually no chance. Time in the market beats timing the market.

Chasing performance. Buying last year's top-performing fund or sector is one of the most reliable ways to underperform. Hot asset classes tend to cool off, and the money that floods in after strong performance often arrives just in time for the decline. Past performance truly does not guarantee future results.

Panic selling. Selling after a crash locks in your losses and removes you from the recovery. The S&P 500 has recovered from every single downturn in its history. Investors who sold at the bottom of the 2008 crisis and waited to "feel safe" before reinvesting missed one of the strongest bull markets ever recorded.

Ignoring fees. An expense ratio of 1.5% versus 0.05% may seem trivial, but over 30 years on a $100,000 portfolio earning 8% gross returns, the high-fee fund would leave you with roughly $432,000 while the low-fee fund would grow to about $935,000. Fees compound against you just as returns compound for you.

Holding too much cash. Safety feels good, but cash earning 0-1% real returns is a guaranteed way to lose purchasing power over decades. The real risk for a young investor is not short-term volatility -- it is not having enough invested in growth assets to meet their long-term goals.

The Bottom Line

Investment returns are not mysterious, but they require patience, discipline, and realistic expectations. Stocks offer the highest long-term returns because they carry the highest short-term risk. Diversification and dollar-cost averaging help manage that risk without eliminating it. The single most important factor in your portfolio's growth is not which stock you pick or when you buy -- it is how long you stay invested and how consistently you contribute. Start early, diversify broadly, keep costs low, and let compounding do what it does best.

Related Calculators