Risk and Return Basics for Successful Long-Term Investing

When it comes to investing and finances, we all know that risk means possibly losing some or all of your hard-earned cash. We also understand that a return on investment (ROI) is the amount you earn on an investment. What many of us may not understand is the relationship between these two forces of finance.

Any investment carries some inherent risk. The relationship between risk and return is often represented by a trade-off — the more risk you take on, the greater your possible return and visa versa. For example, a lottery or penny stocks involve a very high risk of losing your money with the possibility of an extremely high payout. At the other end of the risk spectrum are savings accounts or government bonds which are considered low-risk, however, with low interest rates, these accounts are not likely to earn a lot of money.

There is a balance to strike between the risk you take on and the potential return which could help or hurt your chances at meeting your long-term investing goals. In vetting any investment, always consider where it falls along the risk spectrum. Then, weigh the risk of the potential investment against your personal risk tolerance. Your ability to handle risk, market trends and a lack of information will influence your decisions to purchase, hold or sell an investment.

The Risk vs Return Spectrum

The risk spectrum is helpful in guiding decisions. The best returns come with more risk, but this same risk can mean you get no returns at all or even lose invested capital. So goes the paradox of risk premiums. The key is to know the risk levels of different types of investments and to act according to your particular risk tolerance.

Types of Risk

When most people think of “risk” they translate it as loss of principal, however, there are many kinds of risk. Let’s take a look at some of them:

  • Capital Risk: Losing your invested money
  • Market Risk: Selling an investment at an unfavorable price
  • Interest Rate Risk: A drop in an investment’s interest rate
  • Inflationary Risk: A rate of return which does not keep pace with inflation
  • Default Risk: The failure of the investment institution or company issuing stock
  • Legislative Risk: Changes in laws or tax codes which limits earning potential
  • Liquidity Risk: Limitations on the availability of funds for a specific period of time

For example, stocks could lose value (Capital Risk) or the company could go out of business (Default Risk). “Safe choices” such as bonds, CDs and cash run the risk of failing to keep up with inflation or losing any return with a drop in interest rates.

The trick is to balance risk against return. This is where risk tolerance enters the investment formula. If you do not have a long time to reach your investment goals or are uncomfortable with high risk investment vehicles, you may undermine your efforts to hit a desired earnings target. For instance, those on the verge of retirement could be thrown into a panic at the thought of losing even a fraction of their portfolio. If that’s the case, it is time to either reset your goals or take a bigger dose of courage so you can earn returns to reach your goals.

The good news is that investors can take steps to protect themselves from risks outside of their tolerance level. If your risk tolerance is average, you probably won’t be comfortable investing much of your portfolio in something high-risk, like a venture capital fund. But if you want some of the potentially high returns from such investments, you might buy a small piece, limiting the risk to your overall portfolio.

Protecting Investors Against Risk and other Market Factors

  • Diversify your portfolio by buying an array of investments instead of entrusting your money (and future) to a single investment —be it a company stock, a single industry or market. Purchase a variety of asset types and classes from various markets, industries, companies, etc… Mutual funds are among the cheapest ways to do this.
  • Ask about target-date mutual funds which your broker or fund manager can set up to self-adjust how many risky assets you hold (according to the terms of the mutual fund) to meet goals; adjustments may be set by your age or risk tolerance, with funds getting more conservative as time passes or until you reach certain earnings benchmarks.
  • Put time on your side and avoid short-term volatility. Give your investments a long time to earn returns; five years or more.
  • Get help from a professional if you are not sure which investments are risky or provide the right return to reach your goals. Individuals may choose to seek the advice of their own broker or discuss options with their mutual fund manager(s) or financial advisor.

Most investors find it difficult to diversify effectively across the full spectrum of cash and individual stocks and bonds. Allocate investments among several asset categories to tailor the mix to suit your needs.

For this reason, many investors choose to purchase variable products, such as mutual funds, variable annuities and variable universal life insurance products with the potential for maximizing investment performance, investment flexibility, and convenience. Of course, like any investment, these products involve risk and you should read a prospectus carefully to see if they are right for you before investing.

The returns and principal values of investments in mutual funds, variable annuities and variable life insurance policies will fluctuate and may include various fees. Such fees are also involved with variable annuities and variable life insurance as well as insurance-related charges such as mortality and expense risk charges, surrender charges and cost of insurance.

Strike a Balance Between Risk and Return

Risk and return analysis is the basis of every investment decision you and your trusted broker, mutual fund manager, and financial advisor will make when designing a portfolio and setting goals. In many cases, you will want to aim for the middle of the spectrum, taking on a moderate level of risk in exchange for a moderate return. You can do that by adding a mix of stocks, bonds and other assets in your portfolio.

Continue to improve your financial literacy and keep up to date with market forces to ensure you don’t overexpose yourself to risk, and don’t avoid risk at the cost of earning enough returns to reach your investment goals. Make informed investing decisions; use your rational mind and the advice of an experienced professional to assess risk and return for successful asset allocation in your portfolio.

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