Does Taking on Investment Risk Deliver Higher Returns?
Investment risks are the various hazards that a portfolio of holdings can be exposed to over a period. These risks include systematic and unsystematic risk and exist in all investments—even U.S. Treasurys seen as the most risk-free investment product.
Risks include those of inflation, recession, and other economic hazards that impact the entire market—systematic risks. Other—unsystematic—risks can be reduced through the diversification of holdings and include industry and company-specific hazards such as default or regulatory risks.
Comparing Low Risk Investments to Higher Risk Investments
Each line in the first chart indicates the performance—the return of income—of an investment of $100 into four different investment products.
- The green line shows the growth in value by investing in a safe investment, like short-term certificates of deposit (CD).
- The blue line shows the outcome if invested in five-year Treasury securities, also considered a low-risk investment.
- The orange line shows the performance of your money if it was invested in a balanced fund, like a 50% bond and 50% stock index fund.
- The red line shows principal growth if invested in an S&P 500 Index fund.
As the chart shows, the more moderate an investment is in its risk profile, the lower the corresponding return will be.
Safe, No Risk Investments Face Inflationary Risks
All investments have the risk of a loss of principal. However, some investments have a lower level of risk than others with the trade-off being that you might not earn much of a return income.
With low risk, safe investments you won't have to worry about losing money and may sleep better at night. However, you may not make much investment income either.
Here, your biggest risk is that your investment returns will be less than the rate of inflation. As an example, in 2009, low-risk investments returned less than one half of one percent, yet inflation—as measured by the consumer price index (CPI)—was about 2.7% for that year.
It's hard to live off half a percent of interest a year while costs are rising.
To earn higher returns, you have to be willing to use higher-risk investments. This higher risk means you may have years where you have negative returns.
Low Risk Investments
Low-risk investments, like short-term government, corporate and municipal bonds, deliver consistent returns with minimal risk. In general, this means higher returns than their safer, guaranteed alternatives. Chart three shows the annual returns of an investment in five-year Treasurys.
Most low-risk options are bonds. Bonds are debt securities where the investor basically loans money to the bond issuer in return for an interest income. There are several different types of bonds, and some have a higher risk profile than other bonds.
- Government bonds are considered a very safe investment, as the principal and interest are guaranteed by the U.S. Government.
- Corporate bonds a slightly riskier. Here, the underlying company guarantees the principal and interest. The financial strength of the issuing company determines the bond's rating. Companies like Moody's grade each bond offering—Aaa to Baa3 are considered investment grade. Your primary risk—this is just one of the several risks—is that the issuing company files bankruptcy, putting your principal at risk—known as default risk.
- Municipal bonds are issued by a state or city and usually fund large infrastructure or other improvement projects. Although rare, there have been cases where municipalities defaulted on their bonds.
To earn higher returns with a moderate level of investment risk, you can choose to put a portion of your money in low-risk investments and a portion in investments with a higher level of risk.
Moderate Risk Investments
You can create a diversified portfolio that holds a mix of investments. With a moderate level of investment risk you could choose a mix of bonds and stocks.
Chart four shows the calendar year returns of a portfolio that put 50% of the principal into five-year Treasurys and 50% into a U.S. large-cap stocks through an investment in an S&P 500 index fund.
You can create a similar investment mix by using a balanced fund, or by buying two index funds—one being a bond index fund and the other being a stock index fund.
With moderate risk investments, you will have years where your investments go down in value. However, but if you are willing to stick with your portfolio, it is likely you will have higher long-term returns.
If you want the potential for higher returns, you have to get more aggressive.
Higher Risk Investments
Investing in stocks will move you outward on the investment risk branch. One way you can do this is to invest in an S&P 500 Index fund. The S&P 500 follows the largest 500 U.S. companies that publically trade on an exchange. Investing in the professionally managed fund is less risky than buying and holding each of the individual stocks.
The fifth chart shows the calendar year returns of an S&P 500 Index fund. A stock index fund is considered a higher-risk investment. As such, you can have higher returns in one year, and experience losses in the next year.
There are other options that also fall in this risk category, such as high yield investments, which offer higher levels of current income relative to safer alternatives. These high-yield investments include lower grade—junk—bonds.
Compare Low Risk Investments to Higher Risk Investments
Play it safe or take on additional investment risk, the choice is up to the individual investor. As you can see from the sixth chart, some investments returned a great deal more return than did the other options.
- The green line shows returns for one-month CDs—a very low-risk investment.
- The blue line shows returns for five-year Treasurys another low-risk investment.
- The orange line shows returns for a balanced 50/50 portfolio of five-year Treasurys and U.S. large-cap stocks—the S&P 500 Index—a moderate risk investment.
- The red line shows returns for investing only in the S&P 500 index—a high-risk investment strategy.
Of course, the world of investment products has only be scratched with the options listed here. There are thousands of options all offering their own risk profiles.
Extreme Risk Investments
High-risk investments can deliver fabulous returns, but you also take the risk you could lose everything you've invested. You will hear these options called high-yield investments and they include low-grade junk bonds and penny stocks.
Other high-risk investments playing the options market, or speculating on a piece of real estate.
It's not quite like gambling, because you're investing in an opportunity that you've hopefully taken the time to thoroughly research, but luck will still have quite a bit to do with your results.
For play money or sophisticated investors, these choices are fine. But for those of you who have a limited amount of funds and know you'll need to rely on them in retirement, you probably want to steer clear of higher risk choices.