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There is a positive correlation between risk and return with one important caveat. There is no
guarantee that taking greater risk results in a greater return. Rather, taking greater risk may
result in the loss of a larger amount of capital. A more correct statement may be that there is a
positive correlation between the amount of risk and the potential for return. Generally, a
lower risk investment has lower potential for profit. A higher risk investment has a higher
potential for profit but also a potential for a greater loss.

The risk associated with investments can be thought of as lying along a spectrum. On the
low-risk end, there are short-term government bonds with low yields. The middle of the
spectrum may contain investments such as rental property or high-yield debt. On the high-
risk end of the spectrum are equity investments, futures and commodity contracts, including
options. Investments with different levels of risk are often placed together in a portfolio to
maximize returns, while minimizing the possibility of volatility and loss. Modern portfolio
theory (MPT) uses statistical techniques to determine an efficient frontier that results in the
lowest risk for a given rate of return. Using the concepts of this theory, assets are combined
in a portfolio based on statistical measurements such as standard deviation and correlation.

An investor needs to understand his individual risk tolerance when constructing a portfolio of
assets. Risk tolerance varies among investors. Factors that impact risk tolerance may include
the amount of time to retirement for the investor, the size of the portfolio, future earnings
potential and other types of assets such as a home or pension.