Investment Risk and Return
All investments expose you to some risk. The biggest (and scariest) risk is losing some or even all of the money you've invested. With some investments, you can even lose more than you put in. Another risk is not earning as much as you planned with your investments, which could mean not being able to reach your financial goals.
Typically, the higher the risk of losing money on an investment, the higher the potential return. On the opposite side, lower risk investments usually mean a lower potential return. In other words, if you're trying to achieve a higher return, you have the potential for greater risk.
How much risk are you taking with an investment? You can estimate the risk for a certain investment or category of investments, but you can't know for sure. A lot of factors, large and small, affect investment return. All you really know for sure is how investments have performed in the past. And (you've heard this before) what happened in the past isn't a guarantee of what will happen in the future, but it can give you an idea of the possibilities.
With traditional investments like stocks, bonds, and cash, you can check past performance easily. The rate of return in any single year and the average return over longer periods is a quick internet search away. You'll find that stocks have provided the strongest return over long periods of time, and cash has had the weakest (but safest) return.
You'll see that stock prices can change dramatically. In some years, stock return has been bad (sometimes really bad), in some it has been basically flat, and in others it has been very strong. Cash return, on the other hand, moves within a smaller range. It rarely provides a stronger return than stocks, but it almost never has a negative return.
Risk tolerance is the amount of risk you can live with. Getting a handle on your tolerance level is essential to successful investing. If serious short-term losses would upset you enough to make you sell any stock you own, it might be good for you to avoid more volatile investments. But throwing all of your principal into cash investments also has risk. It's likely that your investment won't earn enough to beat inflation, let alone meet your financial goals.
You can help manage your risk and help stabilize your returns by:
- Allocating your assets among different categories of investments, called asset classes
- Diversifying your investments within each asset class into investments of varying degrees of risk
Of course this comes with a caveat - asset allocation and diversification, while valuable strategies, don't guarantee a profit or protect against losses in a falling market.
Return is Not Just a Number
You measure investment success by seeing what you get back in relation to how much you invested.
- Total Return - This is the change in an investment's value as measured by its market price plus the earnings it provides.
- Percent Return - Percent return is total return divided by the amount you invested. This number helps you compare returns on different types of investments.
- Annualized Return - To get the whole story, you can also look at annualized return. That's the percent return divided by the number of years you own the investment. If an investment increases 10% in one year, that's a stronger performance than a 10% increase over three years.
Risk and Time
High volatility and low liquidity increase risk.
Volatility is how much and how quickly an investment, a portfolio, or an entire market's value changes. The more often and the more quickly an investment's value changes, the higher its volatility. Likewise, the less often and the more slowly prices change, the less volatile the investment.
Volatility adds risk, especially in the short term. Stock prices can increase or decrease dramatically within days as market conditions and investor attitudes change. But over longer periods, such as 15 or 20 years, volatility flattens out and stocks as a group - though not every individual stock - have historically increased in value. With other investments, like options contracts, volatility doesn't diminish over time and may even increase.
Liquidity is a how easy it is for an investment to be converted to cash quickly. Most stocks are highly liquid, meaning that you can sell them quickly to convert to cash. An investment like an Options contract could become completely illiquid, meaning that there is literally no one who would like to buy a contract that you want to sell. In general, the more liquid an investment is, the less risk it poses to your principal.