Making Investment Choices: Risk & Return
Risk and return are part of the same equation when you are investing.
- When you invest in a stock, bond or mutual fund, you are taking a risk that the stock or bond will decline in value.
- In other words, you have no guarantee that you will end up with more money than you started with.
How are Risk and Return Related?
- Stocks are higher risk than bonds and have historically had a higher return.
- Bonds are higher risk than cash investments(certificates of deposit and money market funds) and therefore have had a higher rate of return than cash investments.
- The long (or longer) shot has a higher pay-off than the sure thing.
What is Inflation Risk?
Because the cost of living increases each year (some years a little, some years a lot), you need to get some return on your investments equal to or above the inflation rate, or your savings and investments will lose ground.
- For example, if you keep your money in a savings account or a certificate of deposit that is earning 6% and the inflation rate is 4%, your real return is only 2%.
- If it is earning less than the inflation rate, you are really losing money.
- You may have reasons to do this in the short run, but in the long run, it is not a good idea.
Why is it Important to Diversify?
- By investing in a number of different stocks, bonds and cash investments, you can decrease the risk. Mutual funds are one good way to start spreading your risk, or diversifying.
- Although it is important to have some of your money in cash, bonds and stocks (see WISER Fact Sheet: Don’t Put all of Your Eggs in One Basket), you still have to decide how much you want to put into each, and what funds, stocks and/or bonds you will invest in.
- The advantage of no-load mutual funds is that you don’t have to pay any commissions or sales fees. This makes it less expensive to invest in more than one, big name mutual fund.
