See how risk and reward are related, and how time can lower risk while increasing reward through compounding.
How risk, reward & time are related
Points to know
- Different types of investments have different levels of risk.
- The longer you keep your money invested, the better your odds of overcoming any down markets.
- Your investment gains can grow exponentially over time as your earnings are compounded.
Investing: risky business?
When some people think about investing, they focus on the potential rewards, such as individual stocks that soar in value over short periods of time.
Others focus on the risks. The fear of market downturns, losses during economic stress, or the consequences of relying too heavily on a single investment.
Both perspectives have some truth. All investing involves risk, but not all risks are the same and not all investments behave the same way.
For example, owning a single stock or a highly concentrated position can expose investors to risks that have little to do with the broader market. A company‑specific setback can have a meaningful impact, regardless of how markets overall are performing.
At the same time, even broadly diversified investments are subject to different kinds of risk depending on the asset class:
- Stocks have historically offered higher long‑term growth potential, but their prices can fluctuate significantly, especially in the short term.
- Bonds have generally been more stable than stocks, but they're still subject to risks such as interest rate changes and inflation.
- Cash can help reduce short term volatility, but over time it may lose purchasing power due to inflation over time.
In general, investments with higher potential returns tend to involve greater uncertainty, while more stable investments may offer lower expected growth. The key isn't avoiding risk altogether but understanding it and taking only the risks that align with your goals and time horizon.
A thoughtful investment approach focuses on long term ownership, broad diversification, and balance, rather than short term market movements or attempts to pick winners.
Time is on your side
The ups and downs of the stock market may scare some investors from holding stocks as a part of their portfolio. At the same time, concentrating investments in less volatile investments, such as cash, may feel safer. But shying away from stocks may come at a cost.
When investors avoid short-term volatility by avoiding stocks, they risk not achieving sufficient growth over the long term. Historically, stocks have generally outperformed cash over a 20-year investment horizon.1
Another risk of avoiding stocks is inflation: Should their stock-light portfolio not grow as fast as prices rise, investors will lose purchasing power over time. Over the long run, despite their volatility, stocks have tended to outpace inflation.2
Time and the power of compounding
Time can be one of the most important factors in investing. The longer your money stays invested, the more opportunity it has to grow through compounding.
Compounding means you earn returns not only on the money you invest, but also on the returns that money has already earned. Over time, this can make a meaningful difference.
A simple way to think about it is this: As your investment balance grows, each percentage gain is applied to a larger amount. That’s why starting earlier and staying invested longer can be beneficial.
To be clear, this doesn't mean your money doubles every year or that returns are guaranteed. Investment returns vary from year to year, and all investing involves risk. The examples below are hypothetical and for illustration purposes only.
Compounding in action: A hypothetical example
As a general rule of thumb, an investment earning an average of 6% per year would take about 12 years to double. This isn't a promise of performance, just a way to illustrate how compounding works overtime.
Compounding
For example, imagine investing $10,000 and earning a hypothetical 6% return:
- In the first year, a 6% return would equal $600, bringing the balance to $10,600.
- In the second year, that same 6% is applied to the higher balance, resulting in about $636 in gains, $36 more than the previous year’s return.
As this process continues, the dollar amount of each year’s gain increases because it’s based on a growing balance. By year 20 in this hypothetical scenario, the annual gain would be more than $1,800, and the total account value would be more than triple the original investment.
What if I withdraw the earnings?
An important note. Compounding works only if you keep the earnings invested. What if we adjusted the scenario and we took the earnings out each year.
- In the first year, a 6% return would equal $600, bringing the balance to $10,600. Then, we remove the $600 of earnings, bringing the balance back to $10,000.
- In the second year, that same 6% is applied, resulting in $600 in gains. This is about $36 less than if the money remained invested.
What's the difference?
This may not seem like much in one year, but in 20 years, the total returns are significantly different. Total earnings would be about $22,000 when leaving to compound, versus only $12,000 if withdrawing each year.
This hypothetical illustration assumes a $10,000 investment and an annual 6% return. The illustration doesn't represent any particular investment, nor does it account for taxes, inflation, and the rate is not guaranteed. Values are rounded down to the nearest $100.
Compounding doesn't rely on timing the market or achieving unusually high returns. Instead, it highlights the potential benefits of investing early, remaining invested, and allowing time to work in your favor.
What's next?
The best way to make these concepts work for you is to build a diversified portfolio with the right level of risk.