If you’ve been thinking about getting started with investing, you might’ve already become acquainted with investment-related content. After all, the more you understand the basic principles that underlie modern investing, the better equipped you’ll be to make an informed decision about what you do with your money.
As you continue to consume investing-related articles and videos, you’ll probably start to notice a common thread that unites them all: A disclaimer, sometimes short, sometimes long, and usually located at the end of the content that says something to the effect of:
“All investments involve risk, including the potential loss of principal.”
While this disclaimer might seem like a cynical way for media companies to absolve themselves of any future liability, it’s actually an important reminder of what lies at the core of investing: The risk-return relationship.
Here, we take a closer look at the relationship between investment risk and return, the different types of investment risk you should be aware of, and discuss some of the methods you can use to find the right level of risk for your portfolio.
What is investment risk?
When we talk about how risky an investment is, what we’re really trying to quantify is the potential for loss. An investment that is riskier carries a higher likelihood of loss of principal compared to an investment that is less risky.
There are many different types of investment risk that you should be aware of. These include:
Volatility Risk: Volatility refers to swings in value that an investment may see over time. The greater and more frequent these swings, the riskier an investment is typically seen to be.
Default Risk: How likely it is that the entity you are investing in might default on its obligations to creditors, such as bondholders?
Liquidity Risk: Does the business you are considering investing in have adequate cash flow to cover their operations? How stable is their cash flow?
Political Risk: How might political developments and regulatory frameworks impact the businesses or assets that you are investing in?
Interest Rate Risk: How might the assets you invest in react to rising or falling interest rates?
Inflation Risk: Does your anticipated rate of return keep pace with inflation? If not, you may experience a loss of purchasing power.
The Risk-Return Relationship
In investing, risk and return are typically correlated. This means that an investment which is deemed to be low risk will usually offer a lower potential return on investment, while an investment deemed to be high risk will usually offer a higher potential return on investment.
Exactly how you measure the risk of an investment will depend on the type of asset under consideration.
For example, when it comes to stocks, a company’s market capitalization, history, business practices, stability, rate of growth, consistency of dividend payments, and the industry that they operate within can all be helpful bits of information that you can use to measure how risky it would be to invest in the business. If you were evaluating bonds, however, you’d be more concerned about the issuing body’s credit, its likelihood of default, the potential for interest rate increases, etc.
Generally speaking, if we were to rank the major asset classes from lowest to greatest risk, we’d see:
Cash and Cash Equivalents: These are liquid funds, typically held in a savings account or money market account. While there is virtually zero risk that you will lose your principal by holding cash, there’s also very little opportunity for growth. This opens you up to the possibility of losing purchasing power as a result of inflation.
Certificates of Deposit (CDs): CDs carry a very low risk of losing principal, but like cash they offer low return. But because investing in CDs requires you to lock your money away for a certain period of time (from months to years) they can be considered slightly riskier than cash and cash equivalents.
Bonds: A bond is a loan from an investor (also known as the bondholder) to a borrower, which is usually a government or corporation. In return, the bondholder receives interest payments. With respect to one’s principal investment, bonds are considered less risky than other assets, but not as certain as cash. The risks of rising inflation and interest rates are something that bondholders need to be aware of.
Stocks: A stock is essentially a share of ownership in a company. When an investor purchases a stock, they are entitled to a share in the company’s profits. These profits may be paid out in the form of dividends, or retained by the company to fuel future growth. Of course, there’s no promise that a business will actually earn a profit, or that its profits will grow and translate into a rising stock price. In the event that a business were to go bankrupt, it would result in the total loss of principal for the investor.
Commodities: Commodities are raw materials that can be bought and sold. Food, energy, and metals are some examples of commodities. Commodities are a unique asset class with behaviors that are not highly correlated with stocks and bonds. They may also serve as a hedge against inflation. For this reason, many investors like to diversify their portfolios with commodities. Unfortunately, as a cyclical asset class, commodities are inherently volatile—often experiencing large price swings over short time periods
Digital Assets: Digital assets such as cryptocurrencies, tokens, and NFTs are a relatively new asset class. While they’ve seen explosive growth in the past decade, they’ve also experienced wild swings in price. Additionally, they are largely unregulated, which increases risks to investors who ultimately don’t know how governments will react to them. As such, digital assets are considered to be the assets with the greatest risk, but also the greatest potential return.
How much risk is right for you?
Not sure how much risk you should include in your portfolio? Start by understanding your risk tolerance, your investment timeline, and your desired rate of return.
Your risk tolerance refers to how much risk you are personally comfortable taking with your investments.
Some people have a high tolerance for risk and would be considered more aggressive investors, while others have a low tolerance for risk and would be considered more conservative investors. Those who fall in the middle are typically called “moderate” or “balanced” investors.
A good exercise to determine your risk tolerance is to imagine that you have invested $10,000. Now, imagine that you were to lose 10%, 25%, 50%, or even all of that money. How uncomfortable are you with each of those risks? How likely do you think it is that you might sell out of panic during a market correction (or crash) as opposed to holding steady?
Your investment timeline, or investment horizon, refers to how long you will keep your money invested before you need to access it.
Longer investment timelines typically mean that you can take on a greater level of risk than shorter investment timelines. That’s because you have more time to ride out any market volatility and recover short-term losses. Shorter investment timelines, on the other hand, will typically translate into lower levels of risk.
Required Rate of Return
How much return on investment do you need to realize in order to hit your financial goals within your investment timeline? Generally speaking, the higher your required rate of return, the greater the level of risk you may need to take on in order to hit your goals.
Ultimately, because nobody’s risk tolerance, investment timeline, or desired rate of return are exactly the same, how much risk you decide to take on in your portfolio will be a personal decision.
Balancing Your Investment Risk
As investors, we naturally want to achieve as much reward as possible while taking as little risk as possible. But how do we actually go about putting this desire into practice?
Here at Allio, we know how important risk is to the investment equation. That’s why we’ve designed portfolios for investors of any risk tolerance and investment horizon. No matter where you fall on the spectrum, we have a portfolio that will align with your personal situation and help you work toward your goals.
Additionally, our built-in tools, such as round-up functionality and the ability to set up recurring investments, offer you multiple opportunities to dollar-cost average your investments and reduce volatility over time.