Investing 101: Risk Versus Reward and Risk Tolerance

by Hank

Classic finance theory dictates that investors are rewarded with a higher interest rate when they take on more risk.  For example, even in today’s turbulent market, there is practically no risk that your bank savings account will lose its value.  The same is true with your money market funds.  The $1 share price is set and stable.  Because there is practically no risk, you are rewarded with the lowest interest rates imaginable.

Risk vs. Reward.  The longer you tie up your money in certificates of deposit (CDs), the results are higher interest rates.  Six month CDs national averages have been returning 3.12% lately, one year rates are earning 3.59%, and locking up your money for five years gets you 3.98%.  There is a danger that interest rates will change the longer you have your money tied up.  There is also a danger that the underlying asset of the investment (mortgages, bonds, etc.) may default.  That is why the longer maturities have a higher interest rate. 

Stock on the other hand are riskier than savings account, certificates of deposit, and government bonds.  So, stock investors expect to earn a higher rate of return on their money to compensate them for the added risks that they take.  There is a greater possibility of taking a loss on money invested in the stock market.  The historical required rate of return on individual stocks and mutual fund has varied between 8% and 12%.  So, that is why stock investors require a higher rate of return for their increased risk. 

 

Risk Tolerance.  Everyone’s risk tolerance is different.  Do your investments keep you up at night?  Can you not stand the thought of losing money in the near term even though the odds of your investments gaining in the long term are great?  How soon do you need the money that you have invested?  All of these questions affect your risk tolerance for investments.  There are many quizzes on the internet that you can take to determine your risk tolerance and how aggressive you should invest your money.  Here is an in-depth MSN quiz you can take that is pretty good.  USAA also has a good risk versus return scale that can help you find mutual funds that are best suited for your level of risk that you want to accept. 

Interest rate source: Bankrate.com

Over the coming weeks, I’ll continue to talk about classic finance terms and concepts.  Next, I’ll delve into asset allocation.  Do you have any investing or money terms that you would like to see discussed here?  Let me know by going to the contact page and send me an e-mail.

Other Posts In This Series:
1. Investing 101: Defining Bear and Bull Markets and Recession

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