How much risk are you willing to take? Think of investment and risk as running across a spectrum. Investments with low risk are at one end of the spectrum, and those with high risk at the other. With lower risk investments, safety of principal is critical. You are willing to accept a low rate of return and minimal or no fluctuation in the value of your account. Your tolerance for risk is usually lower when your time horizon is short-term. Typical lower risk investments are bank accounts, certificates of deposit and money market funds, Treasury bills, and guaranteed investment contracts.
With higher risk tolerance, your goal is growth in your portfolio. You are seeking higher returns. You are willing to accept greater volatility (the markets day to day ups and downs) over the short-term because your time horizon is long-term. Typical higher risk investments are growth stocks and growth mutual funds, international stocks and international or global mutual funds, and real estate or real estate mutual funds.
There are several kinds of risk, two of which are market risk and inflation risk.
Market risk is the measure of how much the value of your investment can vary. As we've indicated, different investment vehicles carry different degrees of market risk.
Cash-type accounts (bank accounts and money market funds) are designed to provide safety of principal. You put a dollar in... you get a dollar back with some interest. The value of your account increases because your principal earns interest and your interest earns interest.
Treasury Notes (maturities of two, five, and ten years), are designed to pay you a fixed rate of interest over the life of the instrument. They typically pay a higher return than cash accounts. When the Treasury Note comes due (matures), you get your principal back in full (assuming it doesn't default). However, the value of the Treasury Note prior to maturity can go up or down, depending primarily on the direction of interest rates, making bonds a riskier investment than cash-type accounts. Treasury notes pay interest every six months.
Common stocks offer the potential for an even higher rate of return, but, the value of your investment is subject to greater volatility over the short-term. The stock's volatility is subject to market conditions, the financial well-being of the company, and general economic conditions.
History shows us that investing in common stocks means that the risk in the short term is greater than the risk in the long term. It suggests that those who need their money soon should not to invest in stocks. Common stocks are only for those who have a long-term investment horizon.
Inflation reduces your purchasing power. Your goal should be to increase your purchasing power - and we recommend that you do this by investing to beat inflation by at least 3%.