"What is the chance that I'll lose money?" Every investor asks himself this question when making an investment. And understandably so–nobody likes to lose any of his or her hard-earned money. The key to understanding risk—and getting it to work for you—is to understand the trade-off between risk and reward.
Simply put, to seek greater rewards—such as a higher investment return—you must be willing to accept greater risk. If you wish to reduce risk, you must be willing to accept lower returns.
Historically, foreign stocks have entailed the most annualized risk, followed by U.S. stock and lastly Treasury bills. The more risk you are willing to take, the higher your return potential may be. But, it is possible to seek a high long-term return and keep your risk relatively low with a diversified portfolio.
Of the three primary asset classes, cash equivalents (like money market funds and certificates of deposit) pose the least risk, bonds a moderate level of risk, and stocks the greatest risk. But, in general, cash investments also offer the least rewards, followed by bonds, while stocks have the potential for the greatest return.
Of course there are varying levels of risk associated with different types of investments. Specific industries or sectors that may be more volatile than others involve a higher level of risk. Investments in foreign stocks or market sectors that have specific market capitalizations also tend to be more volatile with increased risk. Small and micro cap stocks are subject to greater risks than larger cap stocks. Investing in new funds offers a certain level of risk since they have limited operating history.
Controlling Your Finances
For some, retirement may seem like years away. For others, it may be right around the corner. Regardless of where you are, it’s still important to take control of your finances and start right now. If you invest even a small amount each month—say, $25 per week—you can accumulate a lot! If you wait, it could potentially cost you lots of money later.
If you start to invest in your 20s and invest $100 each month for just 10 years, then you will have a bigger nest egg than someone who invests $100 per month from age 35 to age 65!
No matter how old you are, if you're just starting to plan and invest for your retirement, you'll need to consider several things:
- Your time horizon
- Your risk tolerance
- Your goals and objectives
- Establish an Emergency Fund
If you're just getting started, you most likely have a while to go before you retire. The longer your time horizon, the greater your chances of reaching your retirement savings goal. Why? Because time gives compounding—earning interest on your interest—a chance to work. And, it gives long-term investors a chance to recover from market downturns.
Your time horizon also helps determine the amount of risk you can take on comfortably. The more time you have before you need your money, the greater the level of risk or volatility your portfolio can withstand (because you have years to recover). Volatility is inevitable, since markets tend to move in cycles. But the longer your time frame, the more volatility you can handle.
Risk Tolerance
To seek greater rewards–such as a higher investment return–you must be willing to accept greater risk. If you wish to reduce risk, you must be willing to accept lower returns. A diversified portfolio may help seek a higher long-term return and keep your risk relatively low. The key: find a comfortable place on the risk/return spectrum. You can accomplish this through diversification and asset allocation.
Goals and Objectives
Maybe you want to save for a dream home or your child’s education. Perhaps you just want to have a nest egg for a rainy day. Once you specify your goals and when you’d like to reach them, it’ll be easier to develop a financial plan.
Establish an Emergency Fund
It's very important to have some money set aside in case of an emergency. Experts recommend three to six months’ worth of expenses in cash or a relatively liquid investment like a money market fund. This money can help get you through emergencies or other times when you might be tempted to dip into retirement savings to get by.
You are right. My parents are very risk averse, yet they constantly complain about their low returns. When I mention mutual funds to them they almost freak out because of the implied risk levels. I guess they will be stuck with low returns while protecting their assets.
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