Updated: April 19, 2013 at 12:00 am
Before you start investing, it is important to understand the relationship between risk and return and as well as what level of risk you are comfortable taking.
Generally, an investment with a higher return will involve taking on more risk. If all investment opportunities provided the same return, everyone would select the least risky choice. As a result, a more risky investment must provide a higher return to attract investors.
At the most basic level, an investment is where one party needs money and another party has money to lend or invest. The investor does not want to lose his money, so the investor demands an increasing level of return as the risk increases.
There are many kinds of risk. One of the most common is market risk, or the risk of losing money in the stock market when the price of stock falls. This can be caused by a change in the overall economic situation, impacting the entire market, or by a change within a specific company. A commonly accepted practice for decreasing this type of risk is diversification into many companies in different industries and geographical locations.
When investing in fixed income or interest earning investments, such as bonds and CDs, the most common risks are default risk and interest rate risk. Default risk is the risk that the bond issuer will become financially insolvent or bankrupt. Bond issuers are rated based on their stability to help investors gauge how much risk they are taking. Interest rate risk is the risk that interest rates will increase after you have purchased a bond or CD, resulting in a drop in the current market value. This is of greatest concern if you own a bond fund or don’t hold an individual bond to maturity.
Two additional risks that many investors fail to consider include opportunity loss and inflationary risk. If you try to avoid risk by avoiding the stock market, you may hurt your chances to earn a decent return. With current interest rates on CDs and treasury bonds so low, conservative investors may be unable to keep up with inflation and build their retirement plans to desired levels. Volatility in the stock market can be very scary, but over long periods it has outperformed most other investments. By avoiding the stock market you take the risk of missing out on the higher returns provided with a more balanced portfolio. You may even lose money, if inflation exceeds the interest rate on your CDs.
Moderation is the key. Investing your entire portfolio in the stock market is far too risky, but investing your entire portfolio in fixed income is also risky. You risk losing the opportunity to earn a reasonable rate of return, to keep up with inflation and to meet your investment goals. The best plan is a diversified portfolio that meets your investment time frame and long-term goals.
Jane Young is a certified financial planner and she can be reached at firstname.lastname@example.org.