One of the most important factors to consider when deciding on an investment is the level of risk involved. Every type of investment product has a level of risk that the investor will assume, and every individual investor has a level of risk they are willing to tolerate. Generally, the higher the potential risk, the higher potential reward, and vice-versa. Let’s look at the basic characteristics of some low-risk and high-risk investments.
Fixed-rate Investments
As the name implies, fixed-rate investments are guaranteed to pay a stated rate of interest on the amount invested. At the end of the investment period, the issuer will also repay the investor the amount they invested. This makes them low-risk investments. Two of the most common fixed-rate investments are certificates of deposit and bonds.
Certificates of deposit, frequently referred to as CDs, are issued by banks. CDs are insured by the Federal Deposit Insurance Corporation (FDIC) for up to $250,000 per depositor, per bank. This means that in the unlikely event that the issuing bank fails, the investor can be sure that they will receive up to $250,000 of their money back.
Bonds, another low-risk, fixed-rate investment, can be issued by governments and corporations. Bonds are not covered by FDIC insurance, but are backed by the credit quality of the government or corporation that issues them. Because they are backed by the full faith and credit of the U.S. government, treasury bonds are considered risk-free. Bonds can be high risk, too: high-yield bonds, sometimes called “junk bonds”, are issued by entities with low credit ratings. They pay better interest rates than higher-quality bonds, but it is more likely that the issuers of these bonds will default on their obligations. As a trade-off for the safety that fixed-rate investments provide, their returns are usually lower than those of higher-risk investments.
Stocks
Though the stock market has historically been one of the most consistently high-performing asset classes, stocks are considered a high-risk investment. Many long-term investors, especially those saving for retirement, invest in stocks using index funds. Though stocks tend to grow over time, there are no guarantees associated with them, and there is a great potential for loss. Look no further than the financial crisis of 2008 for example, when the S&P 500, a common benchmark of the U.S. stock market, fell by 38%.
Certain types of stocks tend to be riskier than others. The stock of a well-established, “blue-chip” company will generally be the least risky type of stock. Stocks of smaller companies, especially those that are in emerging foreign markets or highly speculative industries, are generally more subject to dramatic price swings and high risk of loss.
An extremely high-risk way to invest in stocks is with leveraged exchange-traded funds. The return of these funds is calculated by multiplying the performance of a stock market index by two or three times, magnifying the gain or loss that the index experiences. This can result in incredible gains or devastating losses.
Precious Metals
Precious metals, one of the world’s most enduring investments, have risk characteristics that are a bit different than those of other investments. The prices of these metals can be subject to fluctuation, but many investors consider precious metals to be a way to hedge against inflation and offset losses suffered by their other investments during times of economic distress. Investor Andreas Christian summed it well when he said: “Although precious metals can be subject to volatility, the security they provide in times of economic turmoil is unmatched. Holding some precious metals can actually be an effective way to de-risk a portfolio.”
Clearly, it is important for all investors to understand the risks of investments they are considering, and to ensure that their portfolios are constructed in ways that appropriately reflect the amount of risk they are willing to tolerate.