You'll often see the terms risk and reward grouped together in investment discussions, because they are directly related: The more reward you want from an investment, the more risk you must be willing to assume.
Essentially, all investments carry some form of risk. For example, money market funds significantly reduce your exposure to risk, while stock funds carry a higher risk of principal loss, and bond funds are accompanied by interest rate risk (the risk that interest rate changes will affect the value of your investment).
There are even risks involved with investing very conservatively, such as the risk that inflation may rise faster than your investment returns, which means you lose purchasing power just when you need it most. Additionally, there's the risk that you have invested too conservatively to meet your goals.
Your tolerance for risk
It's important to assess your feelings about risk. Just how comfortable are you with the idea that you could lose investment dollars? Would you be comfortable with an investment that may lose money from time to time, if it offers the potential for higher returns than a bank deposit or money market fund? Going one step further, would you be comfortable with an investment even if it lost 10% of its value over the course of a year?
To help you decide, you should also factor in your current financial situation, and ask yourself these questions:
1. How much outstanding debt (including your home mortgage, auto loan, or credit card payments) do you owe? Make sure you have enough money to pay off those debts before you put money at risk in the stock or bond market. Don't sell yourself short though. Start preparing for the future today, even if you only have a relatively small amount to invest.
2. Do you have enough money set aside for unforeseen emergencies? A money market fund might be the place to set aside some money to take care of unforeseen situations.
Next to this column you'll see a broad spectrum of the major investment categories and their levels of risk and reward. It is important to note that this is just a general reference tool. Even within these categories there are varying levels of risk and reward.
Generally speaking, mutual funds that invest primarily in any one of these types of securities will have risk and reward characteristics similar to that security type.
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Bank certificates of deposit |
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Short-term government securities |
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Short-term money market securities |
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Short-term tax-exempt municipal bonds |
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Mutual funds that invest in the above short-term investments |
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U.S. government bonds
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High-quality U.S. corporate bonds
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Tax-free municipal bonds
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Mutual funds that invest in U.S. government, corporate, or municipal bonds |
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Dividend-paying stocks and bonds |
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Mutual funds that invest in dividend-paying stocks and bonds |
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Growth stocks |
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Emerging growth stocks |
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Mutual funds that invest in growth and emerging growth stocks |
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Although investing can be profitable over the long term, you should know that it can involve a considerable amount of risk. Unlike bank deposits, mutual funds are not insured or guaranteed by the U.S. government or any other financial institution. In other words, you could lose some or all of the money that you invest.
There are risks involved in investing in emerging markets securities, which tend to be more volatile and less liquid than securities traded in developed countries.
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