Understanding Risk

Risk and reward are part of investing

Silver dice on list of share prices
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“No pain, no gain.” How many times have you heard that cliché to describe something you didn’t want to do? Unfortunately, investing carries a certain amount of risk, and with that risk can come some pain, but also some gain.

Regardless of the type of investment, you must weigh the potential reward against the risk to decide if the pain is worth the potential gain. Understanding the relationship between risk and reward is a key piece in building your personal 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

All investments carry some degree of risk. The rule of thumb is “the higher the risk, the higher the potential return,” but you need to consider an addition to the rule so that it states the relationship more clearly: “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 where your comfort level is and be able to correctly gauge the relative risk of a particular stock or other investment.

When you choose to put your money into investments that involve a higher degree of risk 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. Especially likely if you're invested in cash equivalents, Treasury or municipal bonds.
  • Coming up short: Your investments might not earn enough to cover your retirement needs. Possible if you're invested in cash equivalents, Treasury or municipal bonds.
  • 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.

    Risk Profiles Vary

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

    Most people have stocks in their investment portfolio, and for good reason. According to Ibbotson Associates, since 1926 stocks have reliably returned an average rate of 10 percent over time. This is higher than the return you're likely to get from many other investments, especially less risky ones such as bonds.

    However, beware with stocks. You could buy stock in established, blue-chip companies that have a fairly stable stock price and pay dividends each year. On the other hand, if you choose to invest in smaller companies, such as startups or penny-stock firms, you'll find the returns much more volatile and may be at risk of losing your entire investment.

    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 your money to a corporation, municipality, or other government entity, depending on which bonds you buy. Bonds generally provide more safety than stocks, but pay attention to each bond's rating from such rating agencies as Moody's or Standard & Poor's. Ratings act like a credit score or report card, and AAA-rated bonds are your best bet.

    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 sold by corporations, and they promise much higher returns than the 5.5 percent average returns for long-term government bonds (as of 2018). However, high-yield junk bonds carry an extreme amount of risk and in many cases are not even considered investment-grade securities.

    Another type of investment, mutual funds, makes sense for many investors because they're generally 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, and you can also buy shares in mutual funds that hold bonds, gold and other precious metals, shares in foreign corporations, and just about any other asset type that comes to mind. While mutual funds don't completely diversify away risk, you can use them to hedge against risk from other investments that move in the opposite direction.

    Common Investing Questions

    Most people think of investment risk in one way: “How likely am I to lose money?” This statement describes only part of the picture, however. You should consider that risk and others when evaluating an investment:

    • Are my investments going to lose money? (Is safety of principal more important than growth?)
    • Will I achieve my investment goal? (Underfunding your retirement could seriously mess up your plans, for example.)
    • Am I willing to accept more risk to achieve higher returns? (Are my investments going to keep me awake at night with worry?)

    Let’s look at these concerns about risk.

    Am I Going to Lose Money?

    The most common type of risk is the danger 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 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.

    Will I Achieve My Financial Goals?

    The elements that determine whether you achieve your investment goals are:

    • Amount invested
    • Length of time invested
    • Rate of return or growth
    • Fewer fees, taxes, inflation, etc.

    If you can’t accept much risk in your investments, then you will earn a lower return as noted in the previous section. 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.

    Am I Willing to Accept Higher Risk?

    All investors need to find their own 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 also may fail dramatically.

    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 as to lose sleep over it.

    There is no “right or wrong” amount of risk; it is a very personal decision for each investor. However, young investors can afford higher risk than older investors can because young investors have more time to recover if disaster strikes. 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.

    Conclusion

    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.