When talking about investment risks, what do the terms “low risk,” “medium risk,” or “high risk” mean? How is “medium risk” relevant to your goals? In many cases, it is not.
Low-Risk Investments: Safe and Guaranteed
When there is no risk of losing capital, you have a low-risk investment. This is achieved through safe investments: investments that often have a guarantee backed by the U.S. government or an insurance company. You will not achieve high returns with low-risk investments. But your capital is guaranteed.
Low to Minimal Risk Investments
There are many types of bonds (government, corporate, municipal), each with its different investment risk rating. The risk varies depending on the type of bond and the bond’s duration.
The duration of a bond refers to the length of time until the bond matures, which is when the capital must be repaid. With a long-term bond, your money may be tied up for 10, 15, or even 20 years. With a short-term bond, it may only take a year or two for the capital to be safely returned to you.
The longer the time frame before the capital is returned to you, the higher the risk. For corporate and municipal bonds, the lower the rating on the bond, the higher the risk.
Moderate Risk Investments
You can find some balance: a moderate level of investment risk that falls between the safety of the first risk level and the extreme risks of the fourth level. You can find this moderate level of risk by combining high-risk investments, like stock index funds, with low-risk investments, such as short- and medium-term bond funds. Balanced funds will do all of this for you and will create a fund that may have a distribution like “60% stocks / 40% bonds.” Expect moderate-risk investments to provide moderate returns.
High-Risk Investments
High-risk investments like stock index funds are better understood by looking at a specific example.
An index is like a ruler. It measures the performance of a basket of stocks. One widely followed index is the Standard & Poor’s 500 (S&P 500), which tracks the performance of 500 of the largest publicly traded companies in America. These companies include Apple, Amazon, Meta (formerly Facebook), Johnson & Johnson, Tesla, Alphabet, and Berkshire Hathaway, to name a few.
When you buy an S&P 500 index fund, the fund holds a small portion of all 500 stocks. If one of those companies encounters a problem, it will not significantly impact your overall investment.
What are the odds that all 500 major companies in America would fail all at once? If that happens, we have bigger problems on our hands than how to invest our money. For the sake of this discussion about risk, I feel comfortable saying that you can’t lose all your money in a stock index fund. However, you may experience times when the value of your investment drops by 50%. For this reason, this type of investment is considered high risk. But if you stay in it for the long term, you have protected yourself from the risk of losing everything.
Extreme Risk Investments: Individual Stocks
Any time you buy an individual stock or bond (unless it is a government bond), you are taking on a high degree of investment risk, as large companies can go bankrupt and their securities become worthless. When you buy a high-risk investment, the answer to the question “Can I lose all my money?” is “Yes!” You have a significant degree of control over this type of risk.
Avoid
Extreme risk levels by spreading your money across several stocks and bonds. If you are a new or inexperienced investor, do not forget that selecting your securities and continuously monitoring them requires a lot of work and demands a high level of expertise. So, instead of picking and choosing your own stocks and bonds, consider using mutual funds, which do the work on your behalf.
Most Common Mistakes in Measuring Investment Risks
Most investors can distinguish between a safe, low-risk investment and a more extreme investment. The biggest mistake I see investors make is that they do not know the difference between a high-risk investment, where there may be fluctuations but not a total loss; and a very high-risk investment, where there is a chance of losing all their money. That’s the difference between the fourth and fifth items above.
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Sources:
– S&P Dow Jones Indices. “S&P 500,” download “Factsheet — S&P 500 (USD) Factsheet,” page 4.
Source: https://www.thebalancemoney.com/how-to-tell-if-an-investment-can-lose-you-money-2388538
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