You must weigh the potential reward against the risk of an investment 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.
Carry RiskAll 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.
Will I Lose Money?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? (Under-funding retirement, for example.)
- Am I will to accept more risk to achieve higher returns? (Are my investments going to keep me awake at night with worry?)
Lets 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 wont 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
- Less fees, taxes, inflation, etc.
If you cant 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?
Every investor needs to find his or her 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 nights 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 dont 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 dont achieve your financial goals.
Investors can control some of the risk 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.