Risk and expected return: what you’re paid for
In a simple ETF portfolio, expected return is the long-run reward you hope to earn for accepting uncertainty. If an investment’s outcome were predictable, investors would bid its price up until the “extra” return disappeared. The reason stocks have historically offered higher long-term returns than high-quality bonds is that stocks expose you to more uncomfortable outcomes along the way.
For beginners, “risk” is best understood through a few practical measures you can actually feel in real time: volatility (how bumpy the ride is), drawdowns (how deep losses can get from a previous peak), and sequence-of-returns risk (the danger of bad returns happening at the worst possible time—especially near withdrawals).
Three risk measures you’ll encounter in real life
1) Volatility: the day-to-day and month-to-month bumps
Volatility is the size and frequency of ups and downs. A portfolio can be “fine” long term but still swing wildly in the short term. Volatility matters because it tests behavior: the more violent the swings, the more tempting it is to abandon the plan.
- How it shows up: your portfolio is up 6% one month, down 8% the next, then up 4%.
- Why it matters: high volatility increases the chance you sell at the wrong time, even if the long-term expected return is attractive.
2) Drawdowns: peak-to-trough losses (the “how bad can it get?” question)
Drawdown measures the decline from a previous high to a subsequent low. It’s the experience of watching your account fall below its earlier peak and stay there for a while.
- Example: your portfolio reaches $100,000, then falls to $75,000 before recovering. The drawdown is
(100,000 - 75,000) / 100,000 = 25%. - Why it matters: drawdowns are what trigger panic selling. They also determine how long it can take to “get back to even.”
One practical detail: recovering from a drawdown requires a larger percentage gain than the loss.
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| Loss from peak | Gain needed to break even |
|---|---|
| 10% | 11.1% |
| 20% | 25.0% |
| 30% | 42.9% |
| 40% | 66.7% |
| 50% | 100% |
3) Sequence-of-returns risk: when timing matters (especially near withdrawals)
Sequence-of-returns risk is the risk that poor returns happen early in a period when you’re taking money out (retirement or any withdrawal phase). Even if the long-run average return ends up similar, the order of returns can change the outcome dramatically when withdrawals are happening.
Why? Withdrawals lock in losses. If you sell shares after a drop to fund spending, you have fewer shares left to participate in any rebound.
Simple illustration (same average, different outcome):
- Portfolio starts: $100,000
- Withdrawal: $5,000 at the end of each year
- Two-year returns: +20% and -20% (same two returns, different order)
| Order of returns | End of Year 1 | End of Year 2 | Result |
|---|---|---|---|
| +20% then -20% | $100,000 × 1.20 = $120,000; then withdraw $5,000 → $115,000 | $115,000 × 0.80 = $92,000; then withdraw $5,000 → $87,000 | $87,000 |
| -20% then +20% | $100,000 × 0.80 = $80,000; then withdraw $5,000 → $75,000 | $75,000 × 1.20 = $90,000; then withdraw $5,000 → $85,000 | $85,000 |
The difference is small in two years, but over longer withdrawal periods and larger drawdowns, the gap can become meaningful. This is why a portfolio that’s “fine for accumulation” can feel very different when you’re close to spending the money.
Risk capacity vs. risk tolerance (and why both matter)
Risk capacity: your financial ability to take risk
Risk capacity is about math and constraints. It’s your ability to endure losses without derailing your plan.
- High capacity examples: stable income, strong emergency fund, long time horizon, low near-term spending needs from the portfolio.
- Low capacity examples: you’ll need the money soon, you may face job instability, you have high fixed expenses, or you’re near a withdrawal period.
Risk tolerance: your emotional comfort with uncertainty
Risk tolerance is about behavior under stress. Two people with identical finances can react very differently to the same 25% drawdown.
- Signs of lower tolerance: you check balances constantly, you lose sleep during declines, you feel compelled to “do something” when markets fall.
- Signs of higher tolerance: you can stick to the plan through declines, you focus on process rather than headlines.
A workable portfolio needs to fit both. If you have high capacity but low tolerance, an aggressive allocation may still fail because you abandon it at the worst time. If you have high tolerance but low capacity, taking too much risk can force you to sell at a bad time to meet real-life cash needs.
Scenario-based comparisons: all-stock vs. stock/bond mix
The goal here is not to predict exact numbers, but to show how different allocations can feel and behave in the same year. Assume two simple portfolios:
- Portfolio A (All-stock): 100% broad stock ETF(s)
- Portfolio B (Balanced): 60% broad stock ETF(s) + 40% high-quality bond ETF(s)
We’ll use a starting value of $100,000 and two simplified market years: a “bad year” and a “strong year.”
Scenario 1: A bad year (stocks down hard, bonds flat to slightly up)
Assumptions (illustrative): stocks -35%, bonds +3%.
| Portfolio | Return calculation | End value | What it feels like |
|---|---|---|---|
| 100% stocks | $100,000 × (1 - 0.35) | $65,000 | Large drawdown; headlines feel personal; strong urge to “stop the bleeding.” |
| 60/40 | $100,000 × (0.60×0.65 + 0.40×1.03) = $100,000 × 0.802 | $80,200 | Still painful, but meaningfully shallower; easier to stay invested. |
Behavioral angle: The all-stock portfolio offers higher long-term expected return, but the deeper drawdown increases the probability of panic selling. The balanced portfolio may reduce the chance of a catastrophic behavioral mistake.
Scenario 2: A strong year (stocks up a lot, bonds modest)
Assumptions (illustrative): stocks +25%, bonds +4%.
| Portfolio | Return calculation | End value | Common temptation |
|---|---|---|---|
| 100% stocks | $100,000 × 1.25 | $125,000 | Overconfidence; increasing risk after gains; believing “this time is different.” |
| 60/40 | $100,000 × (0.60×1.25 + 0.40×1.04) = $100,000 × 1.166 | $116,600 | Feeling “left behind,” tempted to abandon bonds to chase returns. |
Key takeaway: A stock/bond mix often lags in strong stock years, which can create performance-chasing pressure. The purpose of bonds in a simple long-term portfolio is not to “win” every year; it’s to manage drawdowns, provide ballast, and reduce the odds you quit.
Step-by-step: using these risks to choose a workable allocation
Step 1: Identify your “must-not-fail” time window
Write down when you might need to start withdrawals (even partial) and how flexible that date is.
- If withdrawals are likely within ~5 years, sequence-of-returns risk becomes more important.
- If you’re decades away and adding money regularly, volatility is mostly a behavioral challenge, not a financial one.
Step 2: Stress-test your emotions with a drawdown number
Pick a hypothetical drawdown and ask what you would do.
- Test A: “If my $100,000 became $70,000 and stayed there for a year, would I sell?”
- Test B: “If it became $50,000, would I change my plan?”
If your honest answer is “probably,” you may need a less volatile allocation, even if you technically have the capacity to take more risk.
Step 3: Match allocation to both capacity and tolerance
Use a simple rule: choose the most aggressive allocation you can hold through a bad year without abandoning it. For many beginners, a stock/bond mix can be a practical starting point because it reduces drawdowns and makes the plan easier to follow.
Step 4: Pre-commit to a rebalancing rule (so you don’t improvise)
A rules-based approach reduces behavioral risk by replacing “feelings” with a process.
- Calendar rule: rebalance once or twice per year back to target weights.
- Threshold rule: rebalance when an asset class drifts more than, say, 5 percentage points from target (e.g., 60/40 becomes 66/34).
In a bad year, rebalancing typically means buying what fell (stocks) using what held up better (bonds). In a strong year, it often means trimming what surged. This is emotionally difficult—so having the rule in advance matters.
Behavioral risk: the biggest threat to long-term results
Behavioral risk is the risk that your decisions under stress reduce returns more than markets do. Many long-term outcomes are determined less by picking the “best” ETF and more by whether you can stick with a reasonable plan through volatility and drawdowns.
Checklist: behaviors that derail results (and the rule that prevents each)
- Panic selling after a drop (selling because it feels safer).
Rule to reduce it: define in writing what would justify a change (e.g., life goals changed), and what would not (market declines). - Performance chasing (buying what just did well, selling what did poorly).
Rule to reduce it: rebalance by calendar or threshold; do not change allocation based on last year’s winners. - Checking balances constantly (turning normal volatility into daily stress).
Rule to reduce it: set a review schedule (e.g., monthly or quarterly) and ignore day-to-day moves. - Changing the plan mid-storm (switching allocations during drawdowns).
Rule to reduce it: require a “cooling-off period” (e.g., 72 hours) before any allocation change, and re-read your written plan first. - Overconfidence after strong returns (increasing risk because it feels easy).
Rule to reduce it: keep the same target allocation; if you want to take more risk, increase it slowly and only after a pre-set evaluation date. - Ignoring sequence risk near withdrawals (staying too aggressive right before you need the money).
Rule to reduce it: create a withdrawal “runway” (e.g., a portion in bonds/cash-like holdings) and decide it years in advance, not during a crash. - Making decisions from headlines (reacting to scary or exciting narratives).
Rule to reduce it: only act on your plan’s triggers: contributions, rebalancing dates, and genuine life changes.
A simple written plan template (fill-in)
My target allocation is: ____% stocks / ____% bonds. I chose this because: (capacity) ____ and (tolerance) ____.
I will contribute: $____ per (month/paycheck) into my portfolio.
I will rebalance: (once per year on ____ ) OR (when drift exceeds ____%).
I will not change my allocation because of: market drops, news, or recent performance.
I will consider changing my allocation only if: my time horizon changes, my withdrawal date changes, or my ability to take risk changes.
If markets fall sharply, I will: follow my rebalancing rule and continue contributions (if applicable).
