Investing 101 – Risk Versus Reward and Risk Tolerance

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.  The longer you tie up your money in certificates of deposit (CDs), the results are higher interest rates.  Six month CDs national averages have been returning 0.89% lately, one year rates are earning 1.34%, and locking up your money for five years gets you 2.78%.  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.

Stock 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.  USAA also has a good risk versus return scale that can help you find mutual funds that are best suited for your level of risk that you want to accept.

Interest rate source: Bankrate.com

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{ 3 comments… read them below or add one }

Land Investment July 9, 2010 at 11:11 pm

At the end of the day, risk boils down to how you feel if the investment goes down (even temporarily). If you can live with this then you are risk tolerant. Each individual needs to determine how much stomach they have for the downside because the upside will take care of itself.

Hank Coleman July 10, 2010 at 10:45 am

Great point. I think that the real trouble comes from when we are not honest with ourselves about how much risk we can really stand. Investors think that they can take on more risk than we really can bear.

Split Cents July 11, 2010 at 5:59 pm

A helpful post! One thing I found interesting during the subprime crisis : it is virtually impossible for retail investors to adequately assess risk, especially with respect to fixed income investments. Credit ratings help, but the crisis revealed the problems with relying exclusively on credit ratings. But most consumers can’t actually do go beyond ratings! For example, without access to a Bloomberg terminal, try to pull the underlying indenture agreements for a bond before you purchase it–determine what the terms are, the risk disclosures, the underlying cashflows, etc…

Today, more and more investors have portfolios weighted towards fixed-income. I would go so far as to say retail investors are often expressing uncertainty tolerance and risk ignorance!

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