Risk and Return

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Understanding what’s right for you.

In investing, risk and return go hand in hand. Higher-risk investments have the potential to reward you with higher returns. However, higher risk also means there’s a possibility of losing value or failing to achieve objectives altogether. Higher-risk investments are generally more volatile as well, exposing investors to the risk of having to withdraw money when investments are in a big decline.

All investments have some degree of risk. Even not investing has risk – the risk that your money will lose value due to inflation, leaving you without enough money in the future to cover your needs.

In simplest terms, these are your choices:    More

Equity investments (stocks or stock mutual funds).

  • You can buy stocks individually or purchase stock mutual funds. Individual stock investments in general have the highest return potential along with the highest risk. However, you should be prepared for the amount of management necessary to include individual stocks in your portfolio. If you don’t have the required expertise and time, you may be better off choosing stock mutual funds. (See Stocks)

    Stock mutual funds are easier for most people because they’re professionally managed, for which you pay a fee. Stock mutual funds offer the advantage of buying stocks based upon an investment objective (growth, equity income, S&P Index, etc.) Stock mutual funds provide investors with a more diversified investment. (See Mutual Funds.)

Fixed income investments (bonds, bond mutual funds and CDs).

  • You can buy individual bonds or bond mutual funds. Bonds and bond mutual funds as a category are considered to have less risk and lower return potential than stocks and stock mutual funds. However, there are exceptions: some bond investments can be riskier and have greater return potential than some stock investments.

    Individual bonds promise a specific yield and promise the return of your principal (the amount you invested) when the bond matures. U.S. Treasury bonds offer the advantage of a guaranteed return from the U.S. government. However, bonds do have risks that you should know about, and choosing bond investments may require more time and expertise than some investors have. (See Bonds.)

    Bond mutual funds are easier for most people because they’re professionally managed — you don’t have to select and buy individual bonds on your own. However, bond mutual funds charge management fees and don’t make any promise about the future. (See Mutual Funds.)

  • CDs are investments guaranteed by federally regulated banks. You can buy CDs in a wide range of maturities and yields, to meet virtually any time horizon. In many cases their yields are very competitive with bond investments, but without the risks. Unlike bonds and bond mutual funds, CDs are also protected by the Federal Deposit Insurance Corporation (FDIC), which insures deposit accounts at banks up to specified limits.

Cash equivalents.

  • Money market funds and savings accounts have the lowest risk and return potential. A portfolio with only these types of investments runs the risk of not earning enough over time to meet your goals or exceed inflation, but may be the wise choice for emergency funds or goals less than two years away.

The risk-reward continuum.
Many investments overlap on the risk-reward scale, without hard and fast borders:

  • Some stocks and stock mutual funds have more risk and greater reward potential than others.
  • The least risky stock investments may have less risk and sometimes lower returns than the highest-risk bond investments.
  • Bonds and bond mutual funds have varying degrees of risk and return potential. None are completely free of risk.
  • CDs — which have guaranteed returns with no risk of losing value — can sometimes have higher returns than stocks or bonds.

Understanding your risk tolerance.
The objective of a sound investment portfolio is to maximize return within your risk comfort level. How much risk is right for you?

  • Can you sleep at night if the value of your investments keeps changing or has the potential to fall?
  • Do you have other money to use if you need cash, so that you can lose some or all of your investment without experiencing significant hardship?
  • How long will it be until you need to redeem the investment – do you have time to wait out volatile periods of extreme, often sudden, up and down movements of investments?

Adjusting risk to match your needs.
If you’re a twenty-something trying to build a nest egg for retirement or saving for major expenses down the road, you can probably afford to take significant risks with the majority of your investment portfolio. In middle age, you probably want to start reducing risk somewhat, though you may still need to invest aggressively in order to accumulate enough money for retirement needs.

If you’re approaching or in retirement, and you intend to live off your investment earnings, you most likely want to minimize or even eliminate risk. For many people at this time of life, the best option is guaranteed return investments like CDs, which provide guaranteed safety along with a monthly income stream. For more, go to Financial Life Cycle.

For ways to manage risk, see Time Horizon, Asset Allocation and Diversification.