Understanding Risk
Risk and Reward are Part of Investing
No pain, no gain. How many times have you heard that cliché to
describe something you really didnt want to do? Unfortunately,
investing carries a certain amount of risk and with that risk can come
some pain, but also some gain.
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 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.
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.
Conclusion
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.
