Investment Strategy and Risk

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Investment Strategy and Risk

Risk, in traditional terms, is the relative likelihood that your investment will either lose money or fail to earn it. "Great," you say, "I want to stay away from risk in my investment strategy." Not that easy, unfortunately. The return on investment is the lure companies or governments use to get people to give them money; so the greater the risk, the greater the potential return; this phenomenon is known as the risk premium. Conversely, low-risk investments tend to provide lower returns. There are many kinds of risk, but three basic risk considerations govern investment strategies:

Safety of principal

Will you be able to at least get out of an investment what you put into it? If you are in a position to risk your principal, you have the ability to take advantage of investments with potentially high returns, like volatile stocks or high-yield corporate bonds. If you are a few years away from retirement and you need that money to live on, you may want to choose investments in which your principal is safer. Some investments, such as fixed annuities, guarantee your principal (based on the financial strength and claims-paying ability of the issuing insurance company, loss of principal is still possible). Others, such as US Treasury bonds, are backed by such formidable credit that your principal might as well be guaranteed.

Learn more about the risks of US Treasury bonds.

Reliability of income

If you need regular income to live on, repay loans or reinvest, you will want to choose securities that provide reliable income, such as investment-grade bonds or blue chip stocks. Reliable income, however, usually comes at the expense of large returns and growth potential.

Preservation of purchasing power

Traditionally, we describe risk in the terms discussed above. However, there is also another issues to consider. You may have more dollars in the future than you have today, but can those dollars purchase the same quantity and quality of goods and services as today? We’re talking about the impact of inflation, and when considering a long time horizon, the impact can be as devastating as a market crash. Does the after-tax rate of return of your investment exceed the rate of inflation? You may have to trade off safety of principal to preserve purchasing power.

A good investment strategy is risk-averse. In other words, it seeks to get the greatest return with the least risk possible. You have to determine your own risk tolerance: how much risk you can afford to take on as you seek to get the best return.