Achieving financial success requires that you understand your investment philosophy
and adhere to it when investing. Thus, you also need to know about investment risk and what to do about it.
How to Handle Investment Risk
Pure risk, which exists when there is no potential for gain, only the possibility of loss, . Investments, in contrast, are subject to speculative risk, which exists in situations that offer potential for gain as well as for loss. Investment risk represents the uncertainty that the yield on an investment will deviate from what is expected. For most investments, the greater the risk, the higher the potential return. This potential for gain is what motivates people to accept increasingly greater levels of risk, as illustrated in Figure 13.2. Nevertheless, many people remain seriously averse to risk.
Investors need the promise of a high return to warrant placing their money at risk in an investment. If you want a completely safe investment, you can invest in U.S. Treasury securities , which are backed by the full faith and credit of the U.S. government. With this sort of investment, you loan your money to the federal government and it is later returned with interest. One form of Treasury securities is the short-term Treasury bill, or T-bill, which is a government IOU of one year of less. Because T-bills are risk-free investments, they pay too low a return for most people. If you invest only in T-bills, you will miss out on the significantly higher returns that other investments, such as stocks and stock mutual funds, can provide. When making investments, people demand a risk premium for their willingness to make.
and adhere to it when investing. Thus, you also need to know about investment risk and what to do about it.
How to Handle Investment Risk
Pure risk, which exists when there is no potential for gain, only the possibility of loss, . Investments, in contrast, are subject to speculative risk, which exists in situations that offer potential for gain as well as for loss. Investment risk represents the uncertainty that the yield on an investment will deviate from what is expected. For most investments, the greater the risk, the higher the potential return. This potential for gain is what motivates people to accept increasingly greater levels of risk, as illustrated in Figure 13.2. Nevertheless, many people remain seriously averse to risk.
Investors need the promise of a high return to warrant placing their money at risk in an investment. If you want a completely safe investment, you can invest in U.S. Treasury securities , which are backed by the full faith and credit of the U.S. government. With this sort of investment, you loan your money to the federal government and it is later returned with interest. One form of Treasury securities is the short-term Treasury bill, or T-bill, which is a government IOU of one year of less. Because T-bills are risk-free investments, they pay too low a return for most people. If you invest only in T-bills, you will miss out on the significantly higher returns that other investments, such as stocks and stock mutual funds, can provide. When making investments, people demand a risk premium for their willingness to make.
investments for which there is no guarantee of future success. This risk premium constitutes the difference between a riskier investment’s return and the totally safe return on the T-bill. Industry experts figure the risk premium for most investors is 3 percent or higher, although it varies depending upon the investment alternative. A top-quality corporate bond pays about 2 percentage points more than T-bills, so if the latter rate is 4.5 percent, the potential return to the bond investor should be about 6.5 percent. Because stocks historically earn at least 5 percentage points more than T-bills, the anticipated return to the stock investor should be 9.5 percent (0.045 0.05) or more. Higher-risk investments carry higher risk premiums. A variety of investment alternatives are available to fit each investor’s requirements.
Ultraconservative Investors Are Really Just Savers
The securities markets offer many ways to save that present no risk of losing your principal and still earn respectable albeit limited returns. These financial vehicles include federally insured savings accounts, certificates of deposit, and EE bonds. Ultraconservative investors, especially those who cannot sleep at night if they think their money is at risk, do not consider putting money into investments, choosing instead to stick with the 100 percent safe options backed by the U.S. federal government. Over the course of a year, an ultraconservative investor who places $1000 in one of these options will not lose a penny and will likely gain $20 to $30. In actuality, ultraconservative investors are not really investors. They are savers. As a result, they do not get ahead financially over the long term because taxes and inflation offset most, if not all, of their interest earnings.
Ultraconservative Investors Are Really Just Savers
The securities markets offer many ways to save that present no risk of losing your principal and still earn respectable albeit limited returns. These financial vehicles include federally insured savings accounts, certificates of deposit, and EE bonds. Ultraconservative investors, especially those who cannot sleep at night if they think their money is at risk, do not consider putting money into investments, choosing instead to stick with the 100 percent safe options backed by the U.S. federal government. Over the course of a year, an ultraconservative investor who places $1000 in one of these options will not lose a penny and will likely gain $20 to $30. In actuality, ultraconservative investors are not really investors. They are savers. As a result, they do not get ahead financially over the long term because taxes and inflation offset most, if not all, of their interest earnings.
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