Understanding Investing Risk

Risk and reward are part of investing

Silver dice on list of share prices
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Regardless of the type of investment, there will always be some risk involved. You must weigh the potential reward against the risk to decide if it's worth putting your money on the line. Understanding the relationship between risk and reward is a crucial piece in building your investment philosophy. Investments—such as stocks, bonds, and mutual funds—each have their own risk profile and understanding the differences can help you more effectively diversify and protect your investment portfolio.

Carrying Risk

While the traditional rule of thumb is “the higher the risk, the higher the potential return,” a more accurate statement is, “the higher the risk, the higher the potential return, and the less likely it will achieve the higher return.” To understand this relationship completely, you must know what your risk tolerance is and be able to gauge the relative risk of a particular investment correctly. When you choose to put your money into investments that are riskier than a standard savings or money market deposit account, you run the possibility of experiencing any or all of the following to some degree:

  • Losing your principal: Individual stocks or high-yield bonds could cause you to lose everything.
  • Not keeping pace with inflation: Your investments could rise in value slower than prices. This is more likely to happen if you invest in cash equivalents, like Treasury or municipal bonds.
  • Coming up short: There is a real chance that your investments don't earn enough to cover your retirement needs.
  • Paying high fees or other costs: Expensive fees on mutual funds can make it tough to make a good return. Beware of actively-managed mutual funds or ones with sales loads.

The Different Risk Profiles

Three main investment vehicles are readily available to most investors: stocks, bonds, and mutual funds. Some of these carry more risk than others, and within each asset class, you'll find that risk can also vary quite a bit.

Stocks

Most people have stocks in their investment portfolio, and for a good reason. According to Ibbotson Associates, stocks have reliably returned an average rate of 10% annually since 1926. This is higher than the return you're likely to get from many other investments, especially less risky ones such as bonds. However, be cautious with stocks. You could buy stock in established, blue-chip companies that have a fairly stable stock price, pay out dividends, and are considered relatively safe. Or, you could choose to invest in smaller companies, such as startups or penny-stock firms, where your returns are much more volatile.

Bonds

A popular way to offset some of the risks from investing in stocks is to keep a certain amount of your money invested in bonds. When you purchase bonds, you're essentially lending money to a corporation, municipality, or other government entity, depending on which bonds you buy. Bonds generally provide more safety than stocks and are given a rating from agencies such as Moody's and Standard & Poors. Ratings act like a credit score or report card, and AAA-rated bonds are considered the safest.

When you buy government bonds, you receive a guarantee from Uncle Sam that you'll get your money back plus interest. At the other extreme are junk bonds, which are sold by corporations. Junk bonds promise much higher returns than long-term government bonds, but they're high-risk, and in some cases not even considered investment-grade securities.

Mutual Funds

Mutual funds make sense for many investors because they're managed by professional portfolio managers so that you don't need to worry about watching the market or monitoring a stock portfolio. Mutual funds work like a basket of stocks or bonds, and when you buy shares of a mutual fund, you get the benefit of the variety of assets held within the fund.

You can choose from a wide variety of funds with different risk profiles. Some hold large-company stocks; some blend large- and small-company stocks; some hold bonds; some hold gold and other precious metals; some hold shares in foreign corporations; and just about any other asset type that comes to mind. While mutual funds don't completely take away risk, you can use them to hedge against risk from other investments.

The Chance of Losing Money

The most common type of risk is the danger that your investment will lose money. You can make investments that guarantee you won’t lose money, but you will give up most of the opportunity to earn a decent return in exchange. For example, U.S. Treasury bonds and bills carry the full faith and credit of the United States behind them, which makes these issues the safest in the world. Bank certificates of deposit (CDs) with a federally insured bank are also very secure. However, the price for this safety is a very low return on your investment. When you calculate the effects of inflation on your investment and the taxes you pay on the earnings, your investment may return very little in real growth.

The Chance That You Achieve Your Financial Goals

The elements that determine whether you achieve your investment goals are the amount invested, length of time invested, rate of return or growth, fees, taxes, and inflation. If you can’t accept much risk in your investments, then you will earn a lower return. To compensate for the lower anticipated return, you must increase the amount invested and the length of time invested. Many investors find that a modest amount of risk in their portfolio is an acceptable way to increase the potential of achieving their financial goals. By diversifying their portfolio with investments of various degrees of risk, they hope to take advantage of a rising market and protect themselves from dramatic losses in a down market.

Accepting Higher Risk

All investors need to find their comfort level with risk and construct an investment strategy around that level. A portfolio that carries a significant degree of risk may have the potential for outstanding returns, but it may also cause you to lose your life savings. Your comfort level with risk should pass the “good night’s sleep” test, which means you should not worry about the amount of risk in your portfolio so much that it causes you to lose sleep.

There is no right or wrong amount of risk; it is a very personal decision for each investor. Young investors can afford higher risk than older investors because they have more time to recover if the market declines. If you are five years away from retirement, you probably don’t want to be taking extraordinary risks with your nest egg, because you will have little time left to recover from a significant loss. Of course, a too-conservative approach may mean you don’t achieve your financial goals.

The Bottom Line

Investors can control some of the risks in their portfolio through the proper mix of stocks and bonds. Most experts consider a portfolio more heavily weighted toward stocks riskier than a portfolio that favors bonds. Risk is a natural part of investing. Investors need to find their comfort level and build their portfolios and expectations accordingly.