Which type of investment has the lowest risk, therefore the lowest potential reward?

The Primary Risk of Investing: Permanent Loss of Capital

When you put your hard-earned money into investment vehicles, such as stocks, bonds or mutual funds, you take on certain risks—credit risk, market risk, business risk, just to name a few. But the primary risk of investing is not temporary price fluctuations (volatility), it is the permanent loss of your capital. Otherwise known as investment risk, permanent loss of capital is the risk that you might lose some or all of your original investment, if the price falls and you sell for less than you paid to buy.

All types of investments carry inherent risk(s): a stock price may drastically decline; the issuer of a bond may default; even cash investments (U.S. Treasury bills or money market funds) may lose ground to inflation. So, you are probably asking yourself, “Why would I risk losing some or all of my money?” No matter what investment vehicle you choose, the objective is always the same: to generate more cash for yourself in the future than you have today. If you keep all your money under your mattress, for example, your balance will never grow beyond the amount you save. By investing your money, the potential exists for you to come out ahead—perhaps even far ahead. (See The Power of Compounding)

Risk vs. reward
Typically, an investment that carries higher risk has the potential to generate a higher return (the risk-return tradeoff). In other words, the greater the amount of risk you are willing to take, the greater your potential reward could be. For example, a U.S. Treasury bond is considered one of the safest investments there is; therefore, it provides a low potential return. Stocks, on the other hand, are much riskier than Treasuries and, thus, have the potential to deliver higher returns.
In light of this risk-return tradeoff, you must determine your personal tolerance for risk when choosing investments for your portfolio. Taking on some risk is often the price you must be willing to pay if you want to achieve higher returns.

How do I determine my tolerance for risk?

Your answer will primarily depend on:

• Your age: Generally, the younger you are, the more risk you may be willing to take because you have more time to make up for any losses you might experience along the way.
• Your current financial responsibilities (risk capital): If you are the primary earner for your family, for example, you may want to take on less risk than you would if you were single.
• Your current financial resources (net worth): The larger your investment pool, the more willing you may be to take on risk. Just make sure you can still manage comfortably if you experience any big losses.
• Your time frame: When do you plan to withdraw the money? The markets are subject to short-term fluctuations. If you invest money you plan to use soon, you could be forced to sell when the price is down.
• Your timeline: How long will you need the money to last? As you get closer to retirement, it is often recommended you move at least some of your assets out of more volatile stocks and/or stock funds into income-producing bonds and/or bond funds. You may want to consider leaving at least a portion of your investments in equities (with growth potential) in case you live longer than you expected.

Are there things I can do to help manage risk?

Invest for the long term
Try not to dwell on short-term performance. If you invest in a company with strong business fundamentals, short-term price fluctuations may not affect the long-term value of the company. Short-term periods of volatility can even present a great time to buy more, if you still believe in the company.

Diversify
Diversification simply means investing in a variety of assets, with the hope that positive performance of some investments will neutralize any negative performance in others. The goal of diversifying is to build a portfolio that includes investments that react differently to the same economic factors, limiting the risks associated with “putting all your eggs in one basket.”

Beyond just assets classes, you can diversify even further by allocating your money to different subclasses. For example, within the stock category you can choose subclasses based on different market capitalizations: large companies, mid-sized companies and some small companies. You might also include securities issued by companies that represent different economic sectors. If you're buying bonds, you might choose bonds from different types of issuers: corporations, the U.S. government, etc.

Many retail investors have a limited investment budget, making it difficult for them to put together a diversified portfolio on their own. Buying shares of a mutual fund can provide a readily available source of diversification.

Be honest with yourself about your tolerance for risk.
You may find that the more you learn about how investments work, the more comfortable you feel about taking risk. If not, remember that there are professionals who can help you. Consider investing in an actively managed mutual fund, or hiring a knowledgeable financial advisor to help lead you on the right path. In the long run, the cost of investing your hard-earned money in something you don't really understand can be much higher than the cost of hiring a professional to do it for you.

Remember, a loss isn't truly “locked in” until you sell.
The reason you purchased an investment vehicle in the first place is because you believed in its potential for growth (its value would increase). If your reasoning has changed, or if the investment isn't performing like you thought it would, you may want to consider selling. But before you sell a losing investment, take a moment to decide whether the downturn is simply a short-term blip (maybe even an opportunity to buy more) or whether it is truly a permanent risk to your capital.