How to Tell If an Investment Can Lose You Money
Here's How You Classify Investments as Low, Medium or High-Risk
When you're talking about investment risk, what do terms like "low risk" "medium risk" or "high-risk" mean? How is "medium risk" relevant to your goals? In many cases, it's not.
The question you really need to answer is, "Can I lose my money?" To answer this I prefer to classify investment risk on a scale of one to five, with one representing a low risk, safe, guaranteed investment, and five entailing the highest risk; the risk that you can lose all of your money.
You take on higher levels of investment risk for the opportunity to earn a higher rate of return than what you can receive using only low-risk investments. This makes sense. Yet, if you don't understand the risks your money is exposed to, it can catch you off guard, and instead of making more, you'll end up losing. Understanding the categories below, and the investment returns you might expect from each category will help you avoid unnecessary investment risk.
Low-Risk Investments, Safe & Guaranteed
When you have no risk that you could lose principal, you have a low-risk investment. This is accomplished with safe investments; investments that often have a guarantee backed by the U.S. Government, or by an insurance company. You won't see high returns with low-risk investments. But your principal is guaranteed.
Low to Minimal Risk Investments, Like Short or Intermediate-Term Bond Funds
There are numerous types of bonds (government, corporate, municipal), each with its own degree of investment risk. Risk varies depending on the type of bond, and the term of the bond.
The term of a bond refers to the length of time until the bond matures, which is when the principal must be repaid. With a long-term bond your money may be tied up for ten, fifteen or even twenty years; with a short-term bond, it may be only one to two years until your principal is safely back in your hands. The longer the amount of time before your principal will be returned to you, the greater the risk. For corporate and municipal bonds the lower the rating on the bond, the higher the risk.
Moderate Risk Investments, A Blend Of Stock and Bond Funds
You can find some middle ground; a moderate level of investment risk that falls between the safety of risk level one and the extremes of risk level four. You find this moderate level of risk by blending together higher risk investments, like stock index funds, with lower risk investments, like short and intermediate-term bond funds. A balanced fund will do all of this for you and create and within the fund may have an allocation such as "60% stocks/40% bonds.". Expect moderate risk level investments to deliver moderate returns.
4. High-Risk Investments, Diversified Stock Funds
High-risk investments like stock index funds are best understood by looking at a specific example.
An index is like a ruler. It measures the performance of a basket of stocks. One widely followed index is the Standard and Poor's 500 Index (S&P 500), which tracks the performance of five hundred of the largest publicly traded companies in America. These are companies like Proctor & Gamble, Microsoft, WalMart, Johnson & Johnson, GE, Pfizer and Exxon Mobil, just to name a few.
When you buy an S&P 500 Index fund, the fund owns a little bit of all five hundred stocks. If one of those companies gets in trouble, it has a minimal effect on your overall investment.
What about the odds of all five hundred of the largest companies in America going under, all at once? If that happens, we've got bigger problems on our hands than how to invest our money. For the sake of this discussion about risk, I'm comfortable saying you cannot lose all your money in a stock index fund. Yet you can experience times where your investment value will go down by 50%. For this reason, this type of investment is considered high risk, yet if you're in it for the long term, you've protected yourself from the risk of losing it all.
View this graph of the historical performance of the S&P 500 stock index to get an idea of the volatility of the returns.
Extreme Risk Investments, Individual Stocks
Anytime you buy an individual stock or bond (unless it is a government bond), you take on a high degree of investment risk, as big companies can and do go bankrupt, and their securities become worthless. When you buy a high-risk investment the answer to the question "Can I lose all my money?" is "YES!" You have a tremendous amount of control over this type of risk.
Avoid extremely high levels of investment risk by spreading your money across several stocks and bonds. If you're a new or inexperienced investor, keep in mind, picking your own securities and monitoring them on an ongoing basis is a lot of work, and requires a good deal of expertise, so instead of picking and choosing your own stocks and bonds consider using mutual funds, which do the work for you.
Most Common Mistake in Measuring Investment Risk
Most investors can tell the difference between a safe, low-risk investment and one that's more aggressive. The biggest mistake I see investors make is they don't know the difference between a high-risk investment, where there could be volatility but not a total loss, and an extremely high-risk investment, where there is the possibility of losing all their money. That is the difference between item 4 and 5 above.