The question you really need to answer is, “Can I lose my money?” To answer this, I prefer to classify investment risk on a scale of one to five, with one representing a low risk, safe, guaranteed investment; and five entailing the highest risk—the risk that you can lose all of your money. You take on higher levels of investment risk for the opportunity to earn a higher rate of return than what you can receive using only low-risk investments. This makes sense. Yet, if you don’t understand the risks your money is exposed to, it can catch you off-guard and instead of making more, you’ll end up losing. Understanding the categories below, and the investment returns you might expect from each category, will help you avoid unnecessary investment risk.
Low-Risk Investments, Safe & Guaranteed
When you have no risk that you could lose the principal, you have a low-risk investment. This is accomplished with safe investments: investments that often have a guarantee backed by the U.S. government, or by an insurance company. You won’t see high returns with low-risk investments. But your principal is guaranteed.
Low to Minimal Risk Investments
There are numerous types of bonds (government, corporate, municipal), each with its own degree of investment risk. Risk varies depending on the type of bond and the term of the bond. The term of a bond refers to the length of time until the bond matures, which is when the principal must be repaid. With a long-term bond, your money may be tied up for 10, 15, or even 20 years. With a short-term bond, it may be only one to two years until your principal is safely back in your hands.
Moderate Risk Investments
You can find some middle ground: a moderate level of investment risk that falls between the safety of risk level one and the extremes of risk level four. You find this moderate level of risk by blending together higher-risk investments, like stock index funds, with lower-risk investments, like short and intermediate-term bond funds. A balanced fund will do all of this for you and create a fund which may have an allocation such as “60% stocks/40% bonds.” Expect moderate-risk level investments to deliver moderate returns.
High-Risk Investments
High-risk investments like stock index funds are best understood by looking at a specific example. What are the odds of all 500 of the largest companies in America going under, all at once? If that happens, we’ve got bigger problems on our hands than how to invest our money. For the sake of this discussion about risk, I’m comfortable saying you cannot lose all your money in a stock index fund. Yet you can experience times where your investment value will go down by 50%. For this reason, this type of investment is considered high risk. But if you’re in it for the long term, you’ve protected yourself from the risk of losing it all.
Extreme-Risk Investments: Individual Stocks
Anytime you buy an individual stock or bond (unless it is a government bond), you take on a high degree of investment risk, as big companies can and do go bankrupt, and their securities become worthless. When you buy a high-risk investment, the answer to the question “Can I lose all my money?” is “YES!” You have a tremendous amount of control over this type of risk. Avoid extremely high levels of investment risk by spreading your money across several stocks and bonds. If you’re a new or inexperienced investor, keep in mind that picking your own securities and monitoring them on an ongoing basis is a lot of work and requires a good deal of expertise. So, instead of picking and choosing your own stocks and bonds, consider using mutual funds, which do the work for you.
Most Common Mistake in Measuring Investment Risk
Most investors can tell the difference between a safe, low-risk investment and one that’s more aggressive. The biggest mistake I see investors make is they don’t know the difference between a high-risk investment, where there could be volatility but not a total loss; and an extremely high-risk investment, where there is the possibility of losing all their money. That is the difference between items four and five above.
