My Blog, Your Money

When it comes to investing, it’s important to understand the concept of risk. According to Merriam and Webster, risk is defined as: “possibility of loss or injury.” With words such as injury and loss, it’s easy to see why many people are afraid of risk and thus are reluctant to begin investing. They perceive risk as something to avoid as much as possible. But risk is everywhere (as the insurance companies like to remind us). It’s in the air you breathe, the water you drink, and the food you eat. It’s with you from the moment you wake up to the moment you tuck yourself into bed. Similarly, when it comes to investing, there’s a certain level of risk associated with each investment. Since risk is so prevalent, the best way to handle it is by understanding it so that you can make wise investments.

One of the fundamental axioms of investing is the relationship between risk and return: the more risk that is taken, the greater the potential return. So the investor needs to determine how much risk he or she is comfortable with and invest accordingly. Too little risk and you lose out on higher potential returns that could make the difference between dining on frozen dinners and eating at Le Fancy French restaurant. Every little percent counts. Too much risk and you may not be prepared for the downside should it occur. It’s important to figure out the right combination of risk and return for you so that you will be able to sleep soundly at night without worrying about the sky falling down.

The following is a list of the major types of investments from lowest to highest general risk: bonds, mutual funds, stocks, and options. Keep in mind these are just generalizations so a specific bond may be riskier than a specific stock. Just as men are taller than women in general, there are some women that are taller than some men. Also, just as each person’s height varies, each investment has its own level of risk.

Now, I want to reintroduce you to the effect of time which was first discussed in the post regarding compound interest. As the amount of time increases, risk gradually declines. This is because, over time, the ups and downs of your investments are allowed to even out. So the more time you have to invest, the more risk you are allowed to take. This is good news for those young people out there. Then, as you get older, and the amount of time you have to invest decreases, you should move towards safer investments such as bonds and certificates of deposits.

In summary:

• The higher the risk, the higher the potential return
• As time increases, risk decreases

Bottom line: If you haven’t already, figure out your tolerance for risk, keeping in mind your time horizon, and invest accordingly.