Understanding the relationship between risk and return is essential to understanding why people make some of the investment decisions they do.
First is the principle that risk and return are directly related. The greater the risk that an investment may lose money, the greater its potential for providing a substantial return. By the same token, the smaller the risk an investment poses, the smaller the potential return it will provide.
For example, a startup business could become bankrupt, or it could become a multimillion-dollar company. If you invest in the stock of this company, you could lose everything or make a fortune. In contrast, a blue chip company is less likely to go bankrupt, but you're also less likely to get rich by buying stock in a company with millions of shareholders.
The second principle is that if you can get a better-than-average return on an investment with less risk, you may be willing to sacrifice potentially greater return to avoid greater risk. That's sometimes the case when interest rates go up. Investors pull their money out of stocks, which are more risky because their prices change more quickly and more often, and put it in bonds, which are less risky. The reason is that they're not giving up much in the way of potential return, and they're gaining more protection against potential loss.
The third principle is that you can balance risk and return in your overall portfolio by making investments along the spectrum of risk, from the most to the least. Diversifying your portfolio in this way means that some of your investments have the potential to provide strong returns while others ensure that part of your principal is secure.
Return is a measure of investment gain or loss. For example, if you buy stock for $10,000 and sell it for $12,500, your return is a $2,500 gain. Or, if you buy stock for $10,000 and sell it for $9,500, your return is a $500 loss. Of course, you don't have to sell to figure return on the investments in your portfolio. You simply subtract what you paid from their current value to get a sense of where you stand.
Long-term investors are interested in total return, which is the amount your investment increases or decreases in value, plus any income you receive. Using the same example, if you sold a stock investment for a $2,500 gain after you'd collected $150 in dividends, your total return would be $2,650.
If you want to compare total return on two or more investments that you bought at different prices, you need to figure percent return. You do that by dividing the total return by your purchase price. For example, a $2,650 total return on an investment of $20,000 is 0.1325, or a 13.25% return. In contrast, a $2,650 total return on an investment of $30,000 is an 8.84% return. So while each investment has increased your wealth by the same amount, the performance of the first is much stronger than the performance of the second.
Factors affecting return
If you invest at different times, as most people do, you also need to know your investments' annual percent return to measure one performance against another. To find that figure, you divide the total return from the date of purchase by the amount you invested, to calculate the percentage return. Then you divide the percentage return by the number of years you owned the investment. If you invested $10,000 three years ago, and the total return to date is $2,650, your annualized percent return is 8.83 ($2,650 ÷ $10,000 = 0.2649 ÷ 3 = 0.0883).
When you buy and sell also affects your return. If you buy a stock just before its price jumps, the total return will be stronger than if you bought after the price stabilized or before it began to drop. That's one reason your results on a mutual fund investment may be different from the total return reported for that fund in the financial press or in fund materials.
Taxes also affect return. The total return on a municipal bond may be lower than the total return on a corporate bond, but if you owe no tax on the municipal bond income, it may end up making you more money.
The return on your investment portfolio helps you evaluate the progress you're making toward your financial goals. For example, if your long-term projections require that you achieve a 6% annual return, you may have to reallocate your assets if your return falls below that mark over a period of time.
What complicates the picture is that inflation reduces the buying power of your investment return, as well as your investment income. If the inflation rate is 3% in a year that your investment provides a 6% return, your real return, or return after correcting for inflation, is 3%. The greater your real return, the larger your account value grows.
Real return is the primary reason that emphasizing capital preservation to the exclusion of growth can leave you short financially over the long term. That's because your return on the most conservative investments rarely exceeds the rate of inflation by a full percentage point — and is frequently less. If you're earning 1% on an insured money market account when inflation is 1.5%, you have a negative real return of 0.50%.
Computing real return isn't the end of the line. You also have to correct for income taxes on realized gains and investment income. That's the reason that tax-deferred and tax-free accounts are such attractive ways to invest. You postpone having to subtract the tax that's due — or avoid it altogether.
If you want the financial security and sense of accomplishment that comes with investing successfully, you have to be willing to take some risk. In most cases, risk means the possibility you'll lose some or even all of the money you invest.
Taking risk doesn't mean you have to take flying leaps into untested waters — it means anticipating what the potential problems with a certain investment might be and putting a strategy in place to manage, or offset them.
There is some risk you can avoid. For instance, there's risk in concentrating all of your savings in just one or two stocks or bonds. There's investment risk in choosing to put your money into one company rather than another. And there's management risk that a company's officers may make serious errors. These are examples of what's known as nonsystemic risk because the potential problem lies in the individual investment, not the investment marketplace.
You can manage nonsystemic risk by allocating and diversifying your portfolio, or spreading your assets among a variety of investments. That way, if one of your investments goes down significantly in value, those losses may be offset to some degree by gains, or even stable values, in some of your other investments.
Being too safe
Paradoxically, one of the most common investment risks people fall prey to is not taking enough risk. If you invest very conservatively — or don't invest at all — because you fear losing some of your principal, you run the risk of not meeting your goals and even running out of money during retirement. That's because the rate of return you'll realize will be so low that your investments won't outpace inflation.
There is some risk, called systemic risk, that you can't control. But if you learn to accept risk as a normal part of investing, you can develop asset allocation and diversification strategies to help ease the impact of these situations. And knowing how to tolerate risk and avoid panic selling is part of a smart investment plan.
- Market risk. This is the possibility that the financial markets will drop in value and create a ripple effect in your portfolio. For example, if the stock market as a whole loses value, chances are your stocks or stock funds will decrease in value as well until the market returns to a period of growth. Market risk exposes you to potential loss of principal, since some companies don't survive market downturns. But the greater threat is the loss of principal that can result from selling when prices are low.
- Interest rate risk. This is the possibility that interest rates will go up. If that happens, inflation increases, and the value of existing bonds and other fixed-income investments declines, since they're worth less to investors than newly issued bonds paying a higher rate. Rising interest rates also usually mean lower stock prices, since investors put more money into interest-paying investments because they can get a strong return with less risk.
- Recession risk. A recession, or period of economic slowdown, means many investments could lose value and make investing seem riskier.
- Political risk. With the increasing interaction of the world's markets, political climates around the world can affect the value of your domestic and international investments. A period of instability, for example, can drive the value of your investments down, while political stability and growth can increase their value.
Volatility & risk
Over the course of a day, a month, or a year, the price of your investments may fluctuate, sometimes dramatically. This constant movement, known as volatility, varies from investment to investment, with some investments being significantly more volatile than others.
For example, stock and stock mutual funds tend to change price more quickly than most fixed-income investments, such as bonds.
But it's not always that simple. The price of stock in large, well-established companies — known as blue chips — tend to change more slowly than stock in smaller or newer companies.
Also, some low-rated, high-yield bonds fluctuate in price as least as often as stocks, and offer some of the same opportunities for gain — and for loss.
Volatility poses the biggest investment risk in the short term. But if you can wait out downturns in the market, chances are that the value of a diversified portfolio will rebound, and you'll end up with a gain. If you look at the big picture, you'll discover that what seems to be a huge drop in price over the short term evens out over the long term. In fact, over periods of 15 or 20 years or more, stocks as a group — usually the most volatile investments over the short term — have always increased in value.
Everyone handles risk differently. That's because some people can live with — or can afford to take — more risk than others.
The younger you are, the more investment risk you generally can afford to take. That's because you have the time to wait for a rebound when there is a downturn in the market. But if you've retired or are nearing retirement, you may be counting on income from your investments. That increases the likelihood that you'll want to avoid the risk of losing principal even if you make yourself more vulnerable to inflation risk.
Your life situation also plays a role in how much risk you are willing to take. If you have children who will be going to college in the next few years, or aging parents who depend on you for financial support, you may need to keep more of your portfolio in stable, fixed-income investments, to help cover your short-term expenses. Or, if you're taking the risk of building your own business, you might be more comfortable making investments that you know you can count on.
Your personality matters as well. There's no way around the fact that most investments will drop in value at some point. That's what risk is all about. But most experts agree that it's counterproductive to make investments that either make you so nervous you can't sleep or mean you'll sell in panic at the first sign of a downturn. However, if you're uncomfortable with risk, they also encourage you to learn more about the long-term rewards of well-planned risk-taking.
You can build your risk tolerance — or compensate for it — in several ways:
- Start investing slowly in investments that don't require constant monitoring and gradually expand your horizons.
- Keep track of stock and stock mutual fund performance, so you get used to their values moving up and down.
- Keep track of what's happening in the markets at large.
- Discuss what your impressions of the market are, and talk about any changes you’re considering in investment strategy with your financial adviser.
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