Investments and Risk

The goal of investing money is to produce a profit (a positive return) on the money invested. That positive return may be composed of cash income or capital growth or both. But there is always the possibility that investments will produce a loss or won't produce the expected return or rate of return. To varying degrees, the future value of all investments is always uncertain or unpredictable. The possibility that an investment might under-perform or lose value is called “risk.”

Different degrees and sources of risk. Different types of investment options, however, have different degrees of risk, generally quantified as low-risk, medium risk, and high-risk. Risk also comes from several different sources, not all of which affect every type investment equally. For example, while inflation risk will decrease the value in purchasing power of every type of investment from a “low-risk” passbook savings account to a “high risk” futures vehicle, the market risk associated with a sharp loss of value on the stock market does not decrease the value of the principal placed in the savings account while it very well may decrease the value of the principal invested in individual stocks or in mutual funds. The more common types of investment risk include inflation risk, market risk, interest-rate risk, credit risk (the potential for nonpayment on investments offering fixed income such as corporate bonds), business risk (the potential for business invested in to decline or fail), and liquidity risk.

The reward/risk tradeoff. The risk of loss and the potential reward of return have a direct relationship for investments: in general, the higher the risk to the principal invested, the greater the potential return. Conversely, investments that have lower risks typically offer smaller returns. The differential exists because investors are not likely to put their money in riskier ventures unless they know there's the possibility of a greater reward.

Individual investors such as those saving for retirement should carefully consider the amount of risk that is appropriate for their situation in choosing investment options.

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