Balancing Risk and Return to Meet Your Goals
Note these 3 Basic Rules
Rule one: Risk and return go hand-in-hand. Higher returns mean greater risk, while lower returns promise greater safety.
Rule two: No matter how you choose to invest your money, there will always be a degree of risk involved.
Rule three: Do not invest in anything you do not fully understand.
The pyramid is a useful visual image for a sensible risk-reducing strategy. It's built on a broad and solid base of financial security: a home; money in insured savings accounts or certificates; plus insurance policies to cover expenses if something should happen to your health, your car, your home, your life or your ability to earn an income. As you move up from the pyramid's base, the levels get narrower and narrower, representing the space in your portfolio that is available for investments that involve risk. The greater the risk of an investment, the higher up the pyramid it goes and, thus, the less money you should put into it.
At the very top of the pyramid go the investments that few people should try, such as penny or microcap stocks, commodity futures contracts and most limited partnerships. Most of these lend themselves to manipulation and fraud.
How Much Risk Should You Take?
The risk-reward relationship applies no matter what the investment, who the investment adviser, what the condition of the financial markets or the phase of the moon.
Too many investors seem perfectly comfortable with entirely too much risk -- until the bottom falls out. The basic thing to remember about risk is that it increases as the potential return increases. Essentially the bigger the risk, the bigger the potential payoff. Don't forget there are no guarantees.
Does this mean you should avoid all high-risk investments? For most people yes. For someone who wants to take a "high-risk flyer" (an investment in a theatrical production, for example), it means you should confine it to the top of the pyramid - never occupy a significant portion of your investment portfolio. Invest only as much as you can afford to lose because you might in fact lost it. You should also learn to recognize the risks involved in every kind of investment.
There Are Risks in Everything
Real Estate values go up and down in sync with supply and demand in local markets, regardless of the health of the national economy. Gold and silver, which are supposed to be stores of value in inflationary times, have not fulfilled this expectation. Even federally insured savings accounts carry risks -- that their low interest rate won't be enough to protect the value of your money from the combined effect of inflation and taxes.
What is a prudent risk?
It depends on your goals, your age, your income and other resources, and your current and future financial obligations. A young single person who expects his or her pay to rise steadily over the years and who has few family responsibilities can afford to take more chances than, say, a couple approaching retirement age. The young person has time to recover from market reversals; the older couple may not.