Whether you’re saving for a new home or car, putting away money in your 401(k), or saving for your kids’ education, you need to decide where to put your money. And no matter where you put it, there will be some sort of risk. Understanding the risk associated with your investments and your risk tolerance is necessary for making an informed decision about where to allocate your money.
There are many types of risks. But the most familiar and worrisome to people is the risk of losing your principal. Or to state it differently, ending up with less money than when you started.
There’s no way around it. Investing involves risk. And generally speaking, the more risk you are willing to take, the greater the possibility is for a high return. But there’s also a greater risk of your investment losing its value. The inverse is also true. The less risk you are willing to take, the lower the expected return. That’s the risk/reward tradeoff.
So what is your risk profile?
How comfortable are you with the volatility of the stock market? How will you feel if, after putting away money in your 401(k) for five years, one day when you look at your statement you see that your account has actually lost money? Would you be willing to stay the course?
When you first start investing, most financial institutions provide a questionnaire to guide your investment decisions that takes into account your financial goals, time horizon, ability to sustain a financial loss, and tolerance towards risk. It’s important for you to know how much of a loss you can stomach. It’s also important for you to recognize the tradeoff between expected returns and lowered risk in your portfolio. Once you complete the questionnaire, you’ll be provided with a recommended asset allocation that has the right mix of stocks, bonds, cash, and cash equivalents to help achieve your financial goals within your risk tolerance.
What type of return can you expect without taking on risk?
Three-month treasury bills are considered the safest place to invest your money. They don’t fluctuate in price, and no one expects the federal government default on its financial obligations. Savings accounts below the FDIC insured limit are also considered risk-free.
As you can imagine, the expected return from these investments are much lower compared to stocks, bonds, and other investments. They provide what is referred to as “the risk-free rate of return.” That return amount varies over time based on the interest-rate environment, but the risk-free nature is consistent.
You may be thinking: why not just take the risk-free rate of return and know that your money is safe? Unfortunately, there are other risks beside the risk of losing your principal. And by investing in risk-free assets, you are exposed to at least two of them.
The risk of not meeting your financial objectives: What are you saving and investing for? Retirement? College? Both objectives require a tremendous amount of money. Take retirement for example. We are living longer than ever. It is not unreasonable to expect to live 20 or 30 years after you retire. Maybe even longer. How are you going to have enough money to live on? Saving and investing of course. If you only put your money in risk-free assets you may find you do not have enough money when you retire. The same is true for education or any other financial need. Most of us have limited money we can put away each month. The potential returns on riskier assets, like stocks, can help you to meet your long-term financial needs. Without investing, you may come up short.
Inflation risk: Imagine stashing away $1,000 under your mattress. Ten years later, you decide you want to spend it. But when you go get it, there is only $780. That it was inflation can do — eat away the value of your money. If the rate of return on your money does not keep up with the rate of inflation, you will in effect be losing money. For example, say the average rate of inflation over 20 years is 3%. If the average rate of return on your investments is 2%, you are actually losing 1% a year. It may not look like it when you look at your account balances, but over time your purchasing power will diminish. By accepting the risk associated with assets such as stocks, can you can potentially reduce the risk of inflation.
The lesson? There is no one place you can put your money to alleviate all forms of risk. But you can manage it by having the right asset allocation.