Does Taking on Investment Risk Deliver Higher Returns?

Each line on the graph above shows you what happened if you invested $100 in 1980.

• The green line shows the outcome if that $100 was in safe investments, like short term certificates of deposit.
• The blue line shows the outcome if invested in five year treasury securities, also considered a low risk investment.
• The orange line shows you the outcome if your money was invested in something like a balanced fund, with 50% in bonds and 50% in a stock index fund.
• The red line shows you how your $100 would have grown if invested in an S&P 500 Index fund.

In the following graphs, you can see additional details for each level of investment risk.

Safe investments have no risk of a loss of principal. The trade-off is that you might not earn much of a return. With low risk, safe investments you won't have to worry about losing money, but you may not make much either.

Your biggest risk is that your investment returns will be less than the rate of inflation. In 2009 for example, low risk investments returned less than one half of one percent, yet inflation, as measured by the consumer price index, was about 2.5% 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, which means you may have years where you have negative returns. The next graph in this series shows you how investments with a little more risk compare to investments with no risk.

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. Shown above are the annual returns of an investment in five year Treasury securities.

Most low risk options are bonds. When it comes to bonds, here are a few things to keep in mind:

• Government bonds - These are considered a very safe investment, as the principal and interest are guaranteed by the U.S. Government.
• Corporate bonds - The principal and interest are backed by the financial strength of the company that issued it, so if the company files bankruptcy, your money could be at risk.
• Municipal bonds - The principal and interest are backed by the state or city that issued the bond. 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. Results of such a strategy are shown on the next graph in this series.

You can create a portfolio with a moderate level of investment risk by choosing the right mix of bonds and stocks.

The graph above shows the calendar year returns from 1980 - 2009 of a portfolio that was invested 50% in Treasury securities with five year maturities (as shown in the previous graph), and 50% in U.S. large cap stocks as represented by the S&P 500 index (as shown on the next graph).

You can create a similar investment mix by using a balanced fund, or by buying two index funds; a bond index fund and a stock index fund.

With moderate risk investments, you will have years where your investments go down in value, but if you are willing to stick with your portfolio, it is likely you will have higher long-term 

If you want the potential for higher returns, you have to get more aggressive. The next graph shows the results of a portfolio that is invested 100% in stocks.

The graph above shows you the calendar year returns you experienced if invested in an S&P 500 Index fund over thirty years from 1980 - 2009.

A stock index fund is considered a high risk investment; you can have extremely high returns in one year, and large losses the next year; however, unless Armageddon arrives and all of the hundreds of companies listed in the index go out of business at once, you don't run the risk of losing all of your money (which is a level five investment risk).

There are other options that fall in this risk category, such as high yield investments, which offer higher levels of current income relative to safer alternatives.

On the next graph in the series you'll see all four levels of investment risk charted out side by side, giving you a great visual comparison.

Play it safe or take on additional investment risk? The graph above shows returns for safe investments compared to higher risk alternatives.

• The green line shows returns for one month certificates of deposit; which is a very low risk investment.
• The blue line shows returns for five year treasury securities; another low risk investment.
• The orange line shows returns for a balanced portfolio of fifty percent five year Treasury securities, and fifty percent U.S. Large cap stocks (represented by the S&P 500 Index); a moderate risk investment.
• The red line shows returns for the S&P 500 index; a high risk investment.

What about even riskier options such trading stocks? I cover those on the next and last graph in this series.

High risk investments can deliver fabulous returns, but you also take the risk you could lose everything you've invested.

High risk investments include things like owning individual stocks, starting a business, 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.