Understanding The Relationship Between Risk and Reward In Investments

by Hank Coleman

Classic finance theory dictates that investors are rewarded with a higher interest rate when they take on more risk.  For example, even in today’s turbulent market, there is practically no risk that your bank savings account will lose its value.  The same is true with your money market funds.  The $1 share price is set and stable.  Because there is practically no risk, you are rewarded with the lowest interest rates imaginable.

Risk vs. Reward.  When you tie up your money in certificates of deposit (CDs) for longer periods of time, the results are higher interest rates.  Six month CDs’ national averages have been returning 1.74% lately, one year rates are earning 2.33%, and locking up your money for five years gets you 3.12%.  There is a danger that interest rates will change the longer you have your money tied up.  There is also a danger that the underlying asset of the investment (mortgages, bonds, etc.) may default.  That is why the longer maturities have a higher interest rate.  Many investors combat this trend by investing in a CD ladder.

Stocks on the other hand are riskier than savings account, certificates of deposit, and government bonds.  So, stock investors expect to earn a higher rate of return on their money to compensate them for the added risks that they take.  There is a greater possibility of taking a loss on money invested in the stock market.  The historical required rate of return on individual stocks and mutual fund has varied between 8% and 12%.  So, that is why stock investors require a higher rate of return for their increased risk. 

 

Risk Tolerance.  Everyone’s risk tolerance is different.  Do your investments keep you up at night?  Can you not stand the thought of losing money in the near term even though the odds of your investments gaining in the long term are great?  How soon do you need the money that you have invested?  All of these questions affect your risk tolerance for investments.  There are many quizzes on the internet that you can take to determine your risk tolerance and how aggressive you should invest your money.  Here is an in-depth MSN quiz you can take that is pretty good. 

Do you realize that years ago many of us said that we could handle losing 30% of the value of our stocks in one year?  We said that we would stay the course and keep investing.  But, the truth of the matter is that no one really knew how losing 30% in a year would affect them until it actually happened.  Now, most of us know that we have a relatively low risk tolerance.

Interest rate source: Bankrate.com

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{ 1 comment… read it below or add one }

The Weakonomist May 13, 2009 at 8:03 am

Some would argue that real estate is less risky than stocks. The only reason its risk is perceived as so high is because you can’t diversify as much as you can with other assets. But, as someone who has written extensivley on the subject this is a really well put together guide.

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