UNDERSTANDING RISK AND RETURN
A successful investment
plan must be based on an
understanding of the relationship between investment risk
and return. In planning to meet
each of your goals, you need to
look at your investment time
frame (the amount of time you
have to meet your goal) and
determine how much risk you
are prepared to tolerate during
that period in order to earn the
return needed to reach your
target amount.
The general rule about
risk and return is simple:
Investments with higher risks have
more potential for earning higher
returns. And lower risk investments
generally offer the likelihood of lower
returns.
Many investors don’t
want to risk losing any of the
money they have invested. So,
they decide to be conservative
and put their money only in
what they feel are “safe”
investments. They choose
investments with little chance of
losing any of their invested
principal. This strategy might
be appropriate for a very
short-term goal. For example,
S:docs/jennifer/IRA Packet
suppose you want to buy a new
home in two months and you
have accumulated the money
for the down payment.
Investing that money in a very
conservative low-risk, lowreturn investment is the prudent
thing to do.
However, this strategy
could be very inappropriate if
you are investing for a long
term goal—for example, a
retirement that is 30 years away.
Investing too conservatively
might leave you without the
money you need for a secure
retirement. Your 30-year
investment time frame would
allow you to take more risk
with your investments in the
hope of securing a higher
return than you could obtain
with conservative investments.
Properly balancing the need for
higher returns with your “risk
tolerance” is one of the more
important decisions you will
have as an investor.
YOUR RETURN MAKES
A DIFFERENCE
For example, you want to
retire in 20 years and begin
investing $300.00 a month
toward that goal. If you place
that money in an investment
earning a 5% after-tax average
annual return*, you could have
approximately $123,310 in 20
years.
But if you were to put your
money into an investment
earning an 8% after-tax average
annual return*, you would have
some $176,706 at retirement
time -- $53,396 more.
INVESTMENT RISKS
You cannot totally
escape investment risk (the
chance that the value of your
investment could decline). All
investments include some type
of risk.
Principal or Market Risk
The risk that most investors
think about first is the risk of
losing their principal (the
money invested).
*Average annual total return after taxes
compounded monthly. Returns do not
represent the actual results of any particular
investment. Your returns will differ.
Market values are always
changing, and you can lose
money on any investment.
With stocks of well established
companies and many other
publicly traded securities, the
real risk is almost always of
losing some of the money you
have invested, and the
appreciated value while holding
it rather than experiencing a
total loss. Every investor
should realize the difference
between paper losses (and
gains) that would occur if an
investment were sold and the
real losses (and gains) that
actually result from a sale.
No one likes losses,
whether on paper or real, and
an investor should be keenly
aware of the risk of loss
because of declining market
value. But other investment
risks can be just as costly and
that is why Risk Tolerance
Assessment is so important.
Inflation Risk.
Money can lose some of
its buying power over time.
This is known as inflation risk.
(During rare past periods,
however, including the Great
Depression of the 1930’s
money gained purchasing
power – deflation.) Inflation is a
very serious risk for any
investor because it reduces the
real value of investment returns.
For example, if an investment
earns a 3% after-tax return in a
year when the rate of inflation
is also 3%, the investor only
breaks even in terms of real
value. In other words, the
$1.03 the investor has after one
year will buy only what the
investor’s original would have
bought before any investment
was made.
In any one-year, a few
percentage points of inflation
may not seem a serious
problem. But, over time,
continuing inflation can
compound into a very large loss
of value. Again assuming a 3%
average annual rate of inflation,
a car that costs $20,000 today
will cost $26, 878 in 10 years,
$36,122 in 20 years, and
$48,545 in 30 years. After 20
years of 3% inflation, a house
that sells for $125,000 now will
cost $225,764. It’s not just cars
and houses, of course, but your
overall buying power that
slowly erodes. Future inflation
may be higher or lower than it
is now. Because the inflation
rate is difficult to predict, the
most sensible approach may be
to plan for a moderate rate and
make adjustments as economic
conditions change.
What can an investor do
about the risk of inflation? The
only defense that works is to
earn more than the rate of
inflation. If you choose
investment “safety” over
potential growth, you may
actually be deciding to watch
the value of your money slowly
fade away.
Interest Rate Risk.
Fixed income securities that pay
a specified rate of interest
(bonds, for example) lose some
of their value if market interest
rates rise. The market prices of
outstanding securities of this
type fall when rates rise because
buyers won’t pay the bonds
face value due to the difference
between the interest rate of the
existing security and the higher
rate available from a newly
issued security.
Credit Risk
An investor in a bond or other
debt instrument basically lends
money to the issuer of the
security in exchange for the
promise of interest payments
and the return of the principal
amount at maturity. There is
always a possibility the issuer
may default (not be able to pay
the interest or principal). This
is a credit risk. To compensate
investors for the increased risk,
securities offered by issuers
with poorer credit ratings
generally pay a higher interest
rate than the securities of more
stable issuers.
Types of Investments
Potential Returns and
Relative Risk
You can invest in many
different assets – undeveloped
land, residential rental property,
business property, commodities
and commodities futures, gold
and other precious metals, art,
your family’s business….
However, investing is often
about owning publicly traded
securities like stocks, bonds,
and money market instruments
(or mutual funds that hold such
investments).
Stocks.
A share of common
stock represents an ownership
interest in a company.
Common stock, therefore, has
intrinsic value based on the
networth of the company. On
the stock market, however, the
selling price of any company’s stock is
strictly what buyers are willing to pay.
And no one knows what that
price for a stock (or any other
investment) will be in the
future. Still, the ownership
nature of stocks lets investors
participate in the continuing
growth, if any, of the companies that issue the stocks.
Many companies pay
their shareholders periodic
dividends, (paying so much
money for each share held).
Common stock dividends are
not guaranteed. They are paid
at the discretion of the
company’s board of directors.
Dividends are combined with
changes in market value to
measure the overall yield from
owning a stock or stock fund.
Stocks are a very volatile
investment type; stock values
can swing widely within short
periods. While there has been a
long-term trend of rising stock
prices, losses are possible at any
time if you choose to sell when
prices have declined. The
upside of the volatility (price
risk) is stocks’ potential to make
greater gains than the other
investment types.
In addition, different
types of stocks have differing
risks and potential for gain.
International stocks are
generally considered more risky
than U.S. stocks. Domestic
small company stocks are more
risky than the stocks of larger,
better established companies
(“blue chips”). Yet, in some
past years, the returns of
international and small
company stocks have exceeded
those of large company stocks.
Investing in stocks can
be as simple or complex as your
knowledge, interest, and desires
call for.
You can invest in
individual stocks by buying
them through a broker (and
sometimes directly from the
issuing company by reinvesting
dividends) or by buying them
indirectly through a mutual fund.
This is an investment company
whose business is investing in
other companies’ stocks (or
bonds). A mutual fund
generally sells its shares directly
to you and buys them back
when you want to sell. The
daily value of a mutual fund is
usually calculated from the
market values of its
investments.
How Stock Market
Returns have varied
40.00%
35.00%
30.00%
25.00%
20.00%
15.00%
10.00%
5.00%
0.00%
-5.00%
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