Understanding the Risk & Reward Relationship

Understanding risk is an essential step toward investing for success. All investments involve some risk that you may lose money. Investments, unlike savings and checking accounts at a bank, are not insured by the federal government to protect against market losses. But not all risks are the same. Different types of investments have different types of risks. Successful investors always consider risk and evaluate it against potential rewards when selecting an investment.

Assessing Your Risk Tolerance

One of the first steps in making an investment plan is honestly determining your personal comfort level with risk. Risk tolerance varies from person to person. And your own risk tolerance may change over time as your personal and financial circumstances change.

Is relative stability more important than higher returns, or can you tolerate short-term losses for potential long-term gains? Some investors can calmly accept the possibility that the value of their investments will move sharply higher or lower over very short periods of time. Other investors would have a hard time sleeping at night and might bail out of the market at the worst possible time. These investors often are more comfortable with lower levels of risk. So whether you consider your investment profile to be conservative, moderate, or aggressive, you need to determine how comfortable or uncomfortable you will be when the value of your investment moves up or down.

Assuming you have a long-term investment plan, ask yourself, how much of your investment could you lose in one year and still stick to your plan? Is it 5 percent? 15 percent? 25 percent? Even if you are a low-risk investor, you can still consider diversifying into riskier investments as long as you keep the overall risk of your portfolio low.

Understanding the Risk/Reward Tradeoff

All investments involve some degree of risk, including the possible loss of money. However, making an informed decision to accept some risk also creates the opportunity for greater reward. This fundamental principle of investing is known as the risk/reward tradeoff.

Generally, there are three types of risk that most investors should consider: market risk, interest-rate risk and inflation risk.

MARKET RISK

One type of risk is market risk, or the risk that events in financial markets may lead to losses in the value of your investment. This type of risk is what most people think about when considering risk. Historically, investments with a greater chance of losing value have also been the investments that can produce greater returns.

The two charts below show how returns for different types of investments can fluctuate over time. The first one shows the best and worst year for each type of investment during the period 1993 - 2003. For example, if you had invested in money market instruments during that decade, you would not have lost money, but your return would have been modest. On the other hand, had you invested in stocks or bonds, you would have had the potential for both a greater return and a greater loss. (Keep in mind that many experts believe the `90s produced atypical returns; see Investing for Success: Developing Realistic Expectations for more information.)

Market Risk, 1993 - 2003

Source: Ibbotson Associates, Inc.*

The second chart shows the same type of data for a longer time period, 1973 - 2003. Comparing the two charts, you can see that bonds had the best one-year performance during the longer time period, whereas stocks had the best one-year performance during the 1993 - 2003 period. In general, history suggests that stocks will have the greatest variation in returns.

Market Risk, 1973 - 2003

Source: Ibbotson Associates, Inc.*

INTEREST-RATE RISK

If the value of an investment goes down as interest rates rise, it's subject to interest-rate risk. Bonds and bond mutual funds are affected by interest rate changes. Bond prices and interest rates move in opposite directions: when interest rates go up, bond prices go down, and when interest rates go down, bond prices go up.

To see why this is so, let's say you buy a $10,000 bond paying 5 percent interest with a maturity of 30 years. Now suppose you need to sell the bond after only 10 years. At that time, the interest rate on new bonds is 7 percent. Why should investors purchase a bond paying only 5 percent when they can currently get 7 percent? In order to sell it, you will need to drop the asking price of the bond below its $10,000 face value to approximately $7,900. This will, in effect, allow the new purchaser to earn the going market yield of 7 percent on the bond based upon the lower price.

The opposite is true when interest rates decline. Your bond would then be paying more than what the current market offers, and you could charge a premium price. The new purchaser receives less than he or she paid for the bond when it matures, making up for the higher than marketplace interest payments received in the interim.

INFLATION RISK

It may seem logical that the safest kind of investment is the kind that seeks to preserve your money. Nevertheless, these types of investments may not offer enough protection against an often overlooked risk: inflation. For example, even an investment that you might consider relatively risk free, such as a federally insured bank certificate of deposit, is subject to the risk that inflation will rise faster than your earnings, leaving you with less real purchasing power than when you bought the investment. This type of risk is called inflation risk. Generally, this is the risk of being too conservative in your investments. Take a look at the graph below to see how inflation will erode the value of $1,000 over time, even when inflation is as low as 3 percent.

Purchasing Power of $1,000 at 3 Percent Annual Inflation

Source: Investment Company Institute

Assessing an Investment's Risk Level

Unless you are familiar with the risks involved in an investment, you won't know what to expect from your investment's performance, and you won't know how to properly evaluate it. Although past performance cannot predict future results, looking at past returns will give you a good idea about how an investment has behaved in different market conditions and how it compares to other relevant performance measures.

When looking at past performance, ask yourself if you would have been comfortable with these results. Volatility is a normal part of investing and investors with long-term goals should expect setbacks from time to time. If you maintain a long-term perspective, short-term swings become less significant. Historically, gains have offset losses - for example, on average the stock market has returned about 10 percent per year since 1926.*