We all know that all investments involve some degree of risk, and risk is a fundamental part of any investment. Moreover, none of the investment is meaningful without it. The amount of risk you take should be a personal decision and can be affected by several things.
Understanding of Risk
To some extent, risk can be subjective as only some might find a 50/50 chance of return risk. Meanwhile, most people (if not all) will agree that even a 5% chance of return is a risk. The trouble for new investors is figuring out just where risk really lies and what’s the difference between low and high risks.
Given how fundamental risk is to investment, many new investors believe that it is a well-defined and quantifiable idea. But it’s not. There is still no absolute agreement on what risk really is and how it should be measured.
Experts have often tried to use volatility as a proxy for risk. Notably, it is a measure of how much a given number can fluctuate over time. The wider the range of possibilities is, there are more chances that those possibilities will be bad. Better yet, volatility is relatively easy to measure.
However, volatility is not a great tool to measure risk. Although a more volatile stock or bond indeed exposes the trader to a wider range of possible outcomes, it does not affect the likelihood of those outcomes.
It can be said that risk is the possibility or probability of an asset experiencing a permanent loss of value or below-expectation performance. Suppose a trader purchases an asset anticipating a 10% return. In that case, the possibility that the return will be below 10% is the investment risk. What this also implies is that underperformance relative to an index is not necessarily a risk. If a trader purchases an asset with the expectation that it will return 7% and it returns 8%, the fact that the S&P 500 returned 10% is largely irrelevant.
A low-risk investment might be taken by someone who has more to lose or is not ready to take a risk. Notably, such kinds of investments offer stability and security. However, it’s essential to mention that low-risk investment means there is also less to gain. As the risk is less, the size of a return will be less and is usually about 1 – 5% annually. This is a way to provide a regular income or capital preservation. These include investments in cash or government bonds or money market bonds. We all know that investing in a savings account is less risky than stocks or shares.
Low-risk investing means protecting against the chance of any loss. However, it also means making sure that none of the potential losses will be overwhelming.
Low-risk investment is generally taken by individuals who need money quickly. For instance, if you have $40,000 and need to put a deposit down on a house next year, you will likely choose low-risk. But, if the $40,000 is going towards a beach house in the distant future, you might instead prefer a high-risk investment as there is more time to recover any losses.
There are some examples of low-risk investments:
- High-yield savings accounts;
- Savings bonds;
- Certificates of deposit;
- Money market funds;
- Treasury bills, notes, bonds and TIPS;
- Corporate bonds;
- Dividend-paying stocks;
- Preferred stocks;
- Money market accounts;
- Fixed annuities.
Remarkably, medium-risk investments are considered as more long-term investments with moderate returns. They usually fluctuate by around 5-12%. A medium-risk trader often diversifies their investments by investing in a range of things while still trying to maximize returns. These investments might include shares, bonds, property, or stocks that are good for long-term investment.
Some medium-risk investments are:
- Crowdfunded Real Estate – Fundrise;
- Dividend Paying Stocks;
- Corporate Bonds;
- Municipal Bonds;
- Preferred Stocks.
Investment is called a high-risk investment when there is either a large percentage chance of loss of capital or under-performance—or a relatively high chance of a devastating loss.
A high-risk investment is a good choice for individuals who are ready to take a risk. Usually, it is taken by those with good knowledge or experience in investments. These are individuals who want to achieve the biggest returns possible. Moreover, they can afford to take more risks. As a result, they can get returns of 10-30%.
Remarkably, international stocks are the most commonly thought of as high-risk investments. A high-risk investor will put a high proportion of capital into stocks and shares, seeking out those with the potential for the greatest gains.
There are no straightforward ways to measure risk, and often it comes down to the individual investor’s judgment. However, you should consider that undertaking a high-risk investment is not a decision that should be taken lightly. It should only be done when you can afford to take on the risk.
Let’s see some examples of high-risk investments:
- Crypto Assets;
- Foreign Exchange;
- Hedge Funds;
- Inverse & Leveraged ETFs;
- Private Company Investments;
- Promissory Note;
- Real Estate-Based Securities.
The Rule of 72
If you want to make an investment and see the amount of time it takes to double in value, then rule 72 is for you. Although the Rule of 72 is not a short-term strategy, it is tried and true. It is a simple way to determine how long an investment will take to double, given a fixed annual rate of interest. By dividing 72 by the annual rate of return, investors can see a rough estimate.
The Rule of 72 states that $2 invested at an annual fixed interest rate of 8% would take 9 years ((72/8) = 9) to grow to $4.