Also known as: Investment risk, Risk
Risk
The degree of uncertainty about how an investment will turn out. A higher possible return usually comes with higher risk, but that is a possibility, not a promise.
Risk in investing does not mean "something will go wrong". It means the outcome is not certain: it may turn out better, but also worse, than you expected. The wider the range of possible outcomes, the higher the risk.
That is why risk and return are always mentioned together. Nobody would lend money to an uncertain borrower for the same reward as to a safe one.
Why a higher return costs something
Nobody hands you a higher return for free. If an investment with a high return and no risk existed, everyone would put money into it: demand would push its price up and the return would fall.
Higher risk is therefore the price you pay for the chance of a higher return. It is not a guarantee, though. This is the most important sentence in the whole entry:
A riskier investment does not mean it will earn more. It means it may earn more and may also lose more.
There are investments that are risky and yet have a miserable expected return. High risk is not a value in itself.
Why it matters
Your tolerance for risk decides what you should invest in at all. Two things above all determine it:
Your time horizon. Money you need in a year does not belong in shares: you have no time to wait for a recovery after a fall. Money you will not touch for thirty years can bear far more.
Your reaction. Risk is not just a number in a table. If you sell in panic after a 30% fall, you lock the loss in permanently. The best portfolio is the one you can hold through a bad year.
What to watch out for
Risk is not only volatility. Price swings are just one kind. There is also the risk that a company goes bust, that inflation eats your return, or that you cannot get at the money when you need it.
Zero risk does not exist. Money in a current account is "safe" in nominal terms, but in real terms it loses value. Avoiding risk is itself a decision with consequences: see real vs. nominal return.
How to reduce risk
The most effective tool is diversification, and the second is time. In the FIRE calculator you can play with the expected return and see how much a change in it shifts the outcome, that is exactly the effect of risk on a plan.