Understanding the risk vs. return trade-off is something that takes people in finance entire careers. It is an always developing understanding.

To see some beautiful thoughts developed over some of those aforementioned careers, check out this post by Nassim Taleb and this one by Howard Marks.

Here I’m going to focus on much simpler definitions and relationships.

If you are to take a risk, you have to be rewarded for it. The more risk, the more reward you will demand. This is true for people and also for markets. This is the reason why companies and countries with good credit ratings can sell bonds that pay lower interest rates.

However, it’s important to remember that something that is riskier, won’t necessarily return more over any given time period. In fact, by definition, if it would, it would be less risky. The only return that is higher for riskier assets is the expected return.

In fact, a brief digression. A common example of this principal bleeding into the world is that something can be ‘too good to be true’. In investing, something that looks (or is claimed by a salesman) to be low risk, but promises high returns, is probably a sign that there is hidden risk somewhere.

Using the same example as in my bond primer post, Tesla has both bonds and stock that you can purchase. If you buy the bonds, you expect a lower return, and also a lower variance in the potential outcomes of the investment. You may expect to get 7% return, and a bad outcome is that you lose 10% of your investment, while a good outcome is that you get 10%. In fact, with bonds, the best case outcome is almost always known and capped ahead of time. If you buy Tesla stock, you may expect to get 20% returns, but you may very well lose all of your money, or have returns much higher than 20%. This is risk.

As discussed in the purpose of investing, even if you can get higher returns, you may prefer a lower expected return and lower risk portfolio, especially if both will accomplish your goals equally well.

To many, when they think of bonds, they think of what a retired person’s portfolio is made of. Safe, boring, perhaps low return.

What’s important to understand is what a bond actually is. An example:

If you need to borrow $1000 and I have $1000 and we agree that you’ll pay me $50 per year while you have my money, and in 5 years, you’ll pay me back my $1000, the contract that says you owe me is essentially a bond.

There are plenty of groups that like to borrow money. Governments, corporations, etc.. Some have more risk in their ability to pay you back than others. The risk that you might not get paid back in part or in full is called ‘credit risk’. The US government is generally considered the safest place you can lend your money to. They can of course, just print it if they need to pay you back.

However, there are companies with dubious credit who are looking to borrow money. For instance, Tesla has recently raised cash by selling bonds. Bonds under a certain rating are called ‘junk bonds’ or ‘high yield bonds’, sort of the bond world equivalent of ‘robber barons vs. captains of industry’.

Now, using Tesla as an example, you can buy a bond issued by Tesla or buy Tesla stock. What’s the difference? As we explored with stock, you are an owner and are entitled to a share of the profits. However, before profits are calculated, debt has to be paid! So if you buy Tesla bonds, and Tesla sells just enough cars to pay the bonds, but doesn’t have any profit left over after that, the bond holders will get paid, but the stockholder’s won’t have any profits to distribute or reinvest in their company. Taken to an extreme, when a company goes bankrupt, the bondholders are paid back first before the stockholders get a dime.

So yes, a bond can be very safe, very risky, Very short-term, or very long. As long as you understand the idea; that you are lending money to somebody in exchange for interest in the meantime, you understand a bond!

Most people have heard of a fund. Mutual fund is the most common kind, exchange traded funds (ETF, for short) are close behind.

What you want to understand about a fund, is that it can be made of anything. A fund is really just a sort of holder for actual investments that the fund owns.

When somebody tells me their investments are in “mutual funds”, this doesn’t actually tell me anything about the types of investments they have. A mutual fund can own stocks, bonds, a particular sector, particular geography, you name it.

Similar to stocks, it helps to know why they exist to understand them. Back in the days before Robinhood, it cost a lot to buy shares of stock, and often you had to buy a “round lot”, 100 at a time. This was onerous and expensive, and with information about stocks hard to come by, assembling a portfolio was difficult and expensive.

Enter the mutual fund. A group of people pool their money to buy many different securities, usually stocks and/or bonds, and to have a manager manage it. That’s all it is.

You can have a fund that buys the 500 biggest US companies, and that’s all it does, or you can have a fund where the manager is trying to outperform a target (usually called the “index”). You can have a fund that only invests in biotechnology, or a fund that only invests in bonds from Japan.

A fund is just a convenient way to own a whole bunch of things at once.

A lot of people get intimidated talking about stocks, but I’ve found that most people fundamentally know what a stock is: a fractional ownership in a company.

Things start to get a little fuzzy from there, so I like to first talk about why stocks exist as we know them today. This won’t be a history lesson about joint-stock companies, but rather why you can even buy shares of McDonald’s or Nike in the first place.

Imagine you own a company that sells books. Hard to believe. Pretty soon you are selling a zillion books and making great money, and reinvesting all of that money back into your book selling company. But now, instead of just selling books, you’re selling everything. And people are buying it, and you’re making even more money.

Now, if you want to sell some or all of your company to someone else, you can. But you’ve gotta find a person and make a deal. Far better if you can just sell some to anyone that wants a piece.

Why would you want to sell? Maybe you want some cash now for yourself or your family. Maybe the selling business is great now, but who knows if it will last forever? Maybe you want to get some cash to reinvest in the selling business. It doesn’t matter: if you want to trade a piece (i.e., a share) of your company for cash, you need to sell stock.

Different countries have come up with standards that a company must meet in order to be able to trade shares on public exchanges. They are mostly built around transparency and reporting requirements. If you are going to be able to sell your shares to Joe Public, you have to at least open your books to him.

But I digress. You’ve sold some shares. What now?

Now the owners of all of the shares are entitled to their share (pro-rata) of the profits of the company. When you own stock, you own equity. However, that puts you last in line for those profits. Have people you borrowed money from? If the company stops making money, they have first dibs on the stuff it owns. Risky.

So you own something that might have some nice returns, but if it does poorly, the value could potentially evaporate. So why buy it? Well, at some point the price reaches a level where the future returns the investor expects are enough to compensate him for the risk. So he buys.

When you buy stock, you are literally purchasing a fractional interest in the company. If you buy all of the stock, you own the entire company. That’s actually how it works.

So to recap: stocks are part ownership in a company. They are risky. You buy them because you expect them to have good future returns.

By the time people get into their 20s and 30s and have figured out how to live within their means, they usually arrive at a daunting question: Where should I save my money?

In general, there is a hierarchy of where you should save.

#1 is to get your 401(k) (or 403(b)) match if your employer offers one. It’s very unlikely that this isn’t the best use for your savings because you’re getting an immediate return from your employer.

#2 is where it starts to get tricky, but for me, the next priority is an emergency fund. Everyone’s emergency fund needs are different, but 3 months of expenses is a good place to start.

#3 some might flip this with #2, and depending on the specifics, I might agree. Pay down your high interest debt. What’s high interest? Anything over 8%. Maybe even 6 or 7.

#4 if you have an HSA, max that out, the limit isn’t even that high. If you make the contributions direct from your paycheck, you get to avoid payroll taxes.

#5 max out your Roth IRA. The limit is $5,500 per year, if you really needed to get at it, you could probably withdraw most of it without penalty. It’s money that will never be taxed again, and you’ll probably end up with much more pre-tax money than Roth money in retirement.

#6 head back to the pre-tax retirement account (401(k) or 403(b). Tax deferral is worth a lot. There’s a decent amount of room here; $18,500 per year as of writing. You may want to skip to the next before maxing it out if you have goals earlier than retirement.

#7 taxable investment account. This is apparently the best kept secret in personal finance. You’d be amazed how many people don’t realize you can take cash that would otherwise be in your checking or savings account and invest it in stocks, bonds, or funds. If you’re a high earner that needs to save a lot to get to retirement, you’ll need to get familiar with how this kind of account works.

If you can get all the way to the point where you get your 401(k) match, have an emergency fund, have no high interest debt, max your HSA, max your Roth IRA, max your pre-tax retirement account, and are saving in a taxable account, congratulations. You’re probably crushing the retirement checkpoints.