Risk vs. Reward

Your range of investment choices — and their relative risk factors — is often described as a pyramid. Some experts recommend that you have a solid cash base (enough to cover three to six months of living expenses), the bulk of your portfolio in limited and moderate risk investments, and a small percentage of your total portfolio in the higher risk category.

Of course, your situation may be different, which would mean making other choices. For example, if you have the assurance of a lifetime pension, you might feel more comfortable taking more risk with your personal investments. Or, if you're soley responsible for other people's welfare, you may be reluctant to take much risk at all.

Lower-risk investments, such as government bonds, guarantee that you'll get your money back, plus interest, at maturity, though the market value of your investments could drop. That could mean losing money if you sold before maturity. Higher-risk investments, such as stock in a new company, have no guarantees, and you could lose some or all of your principal. But if the company succeeds, your investment could be worth lots of money.

There's no such thing as zero risk. There are always factors you can't control — such as a recession, an oil embargo, or high inflation.

INVESTMENT STRATEGIES
You can adapt your investment-picking approach from those of financial experts, or you can develop one on your own. Two things you'll want to keep in mind, whatever method you use, are the importance of diversification, or variety, in your portfolio, and the need for a strategy, or plan, to guide your choices.

Remember that the strength of the financial markets is never the result of how well — or how poorly — a single investment does, but how a portfolio of different ones performs over a period of time.

INVESTMENT APPROACHES
The places you choose to put your money reflect the investment strategy you're using — whether you realize it or not. Most people adopt one of three approaches or some combination of them:

Conservative
Take only limited risk by concentrating on high-rated, fixed-income investments and some large-company stock.
Moderate
Take some risks by putting money into stock, stock mutual funds, stock managed accounts, exchange traded funds, and some bonds.
Speculative or aggressive
Take major risks on investments with unpredictable results.

WHAT YOU RISK
You take different risks with different types of investments. With corporate and municipal bonds, the risk is that the issuer will default, and not repay the principal and interest, or that the market value will fall. With stocks, the main risk is loss of principal, if the shares decline in value or the company goes bankrupt. With some leveraged investments, though, you can lose more than the amount you invest if what you expect to happen doesn't occur.

TAKING RISKS
If you take no chances, you run the risk of coming out short. The more you have in the safest investments such as bank savings accounts and short-term US Treasury bills, the smaller your chance of substantial return over the long term. That means an increased risk of outliving your assets because they won't keep up with inflation.

Similarly, the more you speculate, the greater the risk of losing your principal entirely. Often, the more people understand about the principles of investing, the more apt they are to take the moderate approach, balancing their risks against the kind of results they want.

That way, you can also afford to invest a small amount in higher-risk opportunities, and keep some assets insured — and liquid — to meet immediate cash needs.

OTHER RISKS
In addition, you need to take other kinds of risk into account, including volatility and the effect of changing market conditions on investment yield.

Volatility means sudden swings in value — from high to low, or the reverse. The more volatile an investment is, the more profit you can make, since there can be a big spread between what you paid and what you sell it for. But you must also be prepared for the price to drop. If you sell at that point, you may lose money.

When stock or bond markets drop or interest earnings decline, many investors seek investments with the same yield, or income from investment principal, they got in better times. They risk buying lower quality, often unfamiliar, investments. But the search for higher yields can result in higher losses as well.

Investors who sell when market prices drop — as prices do from time to time — not only risk taking an immediate loss but also give up the opportunity to benefit if the prices go back up since they are no longer invested. That doesn't mean you should never sell an investment that loses value, but it does mean you should evaluate the reasons for the drop and the prospect for recovery before you act.

RISK VS. RETURN: WHAT'S THE TRADE-OFF?
When it comes to investing, trying to weigh risk and return can seem like throwing darts blindfolded. Investors don't know the actual returns that securities will deliver, or the ups and downs that will occur along the way.

Looking to the past can provide some clues, though historical returns can never predict future performance. Over several decades, for instance, investors who put up with the stock market's gyrations have earned returns far in excess of bonds or cash investments like Treasury bills.

	COMPOUND ANNUAL RETURN* 1926–2005	Best year	Worst year
Small company stocks	12.7%	142.9% (1933)	-58.0% (1937)
Large company stocks	10.4%	54.0% (1933)	-43.3% (1931)
Long-term corporate bonds	5.9%	42.6% (1982)	-8.1% (1969)
Cash (Treasury bills)	3.7%	14.7% (1981)	-0.02% (1938)
* Price changes of securities plus dividends and interest income Source: © Computed using data from Stocks, Bonds, Bills & Inflation 2006 Yearbook^TM, Ibbotson Associates, Chicago (Annual updates work by Roger G. Ibbotson and Rex A. Sinquefield). Used with permission. All rights reserved.

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