True or false: The greater the potential profits, the greater the risks you have to take?
Absolutely true. If anyone tries to tell you otherwise, say goodbye and walk out the door.
It is impossible to make money on any investment without facing a certain degree of risk that you will lose money. In other words, there are no sure things when it comes to investing. And various types of investments carry varying degrees of risk.
So, how can you invest your money safely and still strive for large profits? Use these three simple rules:
Rule #1: Keep a healthy percentage of your money in investments that are highly unlikely to ever go down in value. These are your keep-safe — or emergency — funds. The following are generally considered low-risk, conservative investments: Insured savings accounts, savings bonds, money market funds, certificates of deposit (CDs), Treasuries, and other government securities.
Rule #2: Allocate a modest percentage of your money to more aggressive investments that have the potential to grow your wealth rapidly. These are funds you can afford to lose. The following investment types are generally considered moderate risk — but can take on more risk in volatile markets — stocks, corporate bonds, mutual funds, and real estate. Options, futures, and short selling are generally considered higher-risk, more aggressive investment strategies.
Rule #3: Make sure the aggressive investments have clearly defined or strictly limited risk.
Each investor approaches his or her investment decisions from a unique perspective. What is an acceptable level of risk for one person, may be completely unacceptable for you. Likewise, a mutual fund or stock that is perfect for someone else may be totally inappropriate for you due to factors such as:
How much risk you are comfortable taking
Your age and the number of years you have before retirement
Your income level and tax rate
Your other existing investments and personal net worth
Your expectations about investment performance
Therefore, before investing, it is critical for you to understand your own attitude toward risk and your Risk Tolerance level. In other words, you need to determine how comfortable you will be when the value of your investments move up or down.
Successful investors carefully consider the risk of an investment and evaluate it against the potential reward — so, it is important for you to familiarize yourself with the risks involved in a particular investment. Past performance of the investment is one way to evaluate this risk — but beware, it cannot predict future performance. However, if you would not have been comfortable with how the investment performed in the past, you should probably not invest in it now.
Types of Risk
There are several types of risk that every investor should understand.
Market risk: This is the risk that activity in the financial markets may lead to losses in the value of your investment. This is what most people are talking about when they refer to general investment risk.
Inflation risk: Inflation will have an impact on the long-term return of your investments. When the rate of inflation rises, investments have less purchasing power. In fact, some relatively "risk-free" fixed-interest investments may fail to keep pace with the rate of inflation, thereby effectively eroding the value of your money over time.
Interest Rate Risk: This is the risk that interest rates will rise, resulting in a current investment's loss in value. In simple terms, the price of a fixed-income investment will fall when interest rates rise.
Currency Risk: This is the risk that if the domestic currency becomes stronger, you will experience a currency loss on any foreign securities you hold.
Asset-Class Risk: This risk includes missing out on the higher returns of one asset class because all of your investments are in another asset class that is performing less well.
Credit Risk: Specific to bonds, this is the risk that the government or the company will default and will not repay principal and interest to the bondholders.
Maturity Risk: Specific to bonds, this is the risk that the value of a bond may change from the time it is issued to maturity. The longer the maturity, the greater the risk.
Political or Legislative Risk: This is the risk that legislative changes, like changes to the tax laws, will affect your investments.
Company Risk: This is the risk that the company in which you invest will fail to perform as expected or may even fail.
Timing Risk: This is the risk of buying or selling a security at the wrong time.
Liquidity Risk: The risk that arises from the difficulty in selling an asset or investment.
