The Varying Degrees of Investment Risk, Where Do You Fit In?
I’ve met investors that have been way too conservative. And I’ve met investors that are way too aggressive. And as we all know, every investor has a different comfort level with the amount of risk they take. There are investors that can’t sleep at night if they lose a few percent in the stock market, and there are investors that aren’t satisfied unless they double their money every year. While there is no perfect investment risk level that applies to everyone, clearly an appropriate level of risk is somewhere between being in all cash and investing in options. Where you stand depends mainly on your tolerance for risk, as well as what you’re comfortable investing in. We’ve thought of, and listed below, some varying degrees of investment risk levels that showcase low to high risk investments. Use the list to see where you fit in. Theoretically, a risk level of about 3 would be ideal.
Risk Level 1 – Lowest Risk Investments
The lowest level of risk that an investor can take is to not be an investor at all. That means keeping all of your money in cash. Whether you hide money under your matress or bury it in your backyard, keeping all of your money in straight cash uses the least amount of risk. That is, investment risk. Actual risk that someone steals your money or that you keep up with inflation are actually very high if you take an approach like this, however, you won’t lose any money because of a bank or other type of investment loss.
The next type of investment that also fits this category are savings accounts, money market accounts, and certificates of deposit. All of these investments can be bought at a bank or at a brokerage. These types of investments offer extremely low rates of return and, often even fall behind the rate of inflation, which means you are actually losing buying power when you own some of these investments. With that said, certificates of deposits could be the outlier here, as they can offer higher rates of return than the other two assets, especially when interest rates are not at rock bottom levels. Also, all of these investment returns are based on current interest rates. When interest rates are extremely low, these investments return almost nothing. When interest rates are high, these investments have much better returns and still offer low risk.
Risk Level 2 – Below Average Risk
The next level of risk includes investments that are more risky than cash or cash equivalent funds (see risk level 1). These types of investments include buying highly rated and government bonds, blue chip stocks, dividend stocks, and even insurance annuities that offer a guaranteed return. Of course, these types of investments are only below average risk if you buy a diversified portfolio of them. For example, buying a single bond or blue chip stock is risky because you would be taking on the company specific risk associated with that underlying company or municipality. However, if you buy a diversified mix of these investments, usually obtained by buying a bond fund or blue chip mutual fund, you get rid of much of the company specific risk and, because these investments are backed by highly rated balance sheets, you typically have less risk than other investments.
Regarding annuities, its true that they have less risk because they guarantee certain return levels. However, be aware that you pay upfront for the added security of these investments. Because of this arrangement, these types of investments are typically much lower returns than if you invested the money yourself in a mix of stocks and bonds. The reason people choose these investments is because they are risk averse and need a guaranteed return, usually during retirement. Also, investing in some of these annuities can lower a person’s assets so that they can often qualify for aid, healthcare, or retirement living help that they otherwise wouldn’t qualify for.
Risk Level 3 – Investments with Medium Risk
Medium risk investments include traditional stocks, mutual funds, real estate funds and corporate bonds. While taking on just one of these investments would be risky, building a balanced portfolio of stocks, bonds and real estate would hold an overall risk level somewhere in the medium risk category. Of course, that would depend on the specific mutual fund categories and bonds that you bought, but generally speaking, if you do your homework and diversify your investments across these categories, you should be in the average risk tolerance level and should be able to get market performing returns above the returns offered by the lower risk levels.
Regarding real estate, while buying individual real estate is risky, there are many different ways to buy real estate through the use of funds or ETFs. The most common form of real estate investment are through trusts called REITS (real estate investment trusts) whereby you buy a share in a company that invests in real estate. It is different than other funds because REITs are required to pay out a large percentage of their cash flow, making them a good source for dividends. REITs invest in such real estate as apartments, storage units, commercial and industrial, as well as focus on different geographies and investment sizes.
Risk Level 4 – Above Average Risk
Higher risk investments include investments in emerging markets, high growth stocks, high risk sectors, individual stocks, and buying real estate. While you should always diversify your investments across many sources, even diversified portfolios of investments in emerging markets and in ultra high growth stocks can be risky. And regarding individual stocks, many people take on too much risk because they heavily favor a certain stock that they either really like or that they have access to for some other reason. An example would be most employee stock plans. Owning too much stock in your employer is very risky. That’s because if your company fails or falters, not only will your worth decline rapidly, but you also stand to lose your job at the same time.
And regarding investing in real estate, if you invest in an individual property it would fit into this category. That’s because owning a single property is much more akin to one-off risks than owning a diversified holding of real estate. When buying your own property, you face the risks that your neighborhood could decline, that your city could decline, that your state’s taxes could rise, and of course you have the added risk of having a large loan taken out (leverage), which makes small swings in the value of your investment affect your return dramatically. All of these reasons make investing in real estate risky. With that said, you’ll also have a good chance of making good returns, especially if you can manage the property yourself. That’s because a large share of your profits don’t go to an administrative staff, like happens at real estate funds.
Risk Level 5 – Highest Risk Investments
The highest risk investments include speculating on stocks, buying penny stocks, using naked call and put options, and flipping houses. All of these investments carry nearly outlandish risk. Investors that speculate on stocks often buy on rumors that never materialize, or if they do, the stock moves in the wrong direction because everyone else was speculating also. And penny stocks, which typically trade for a few cents, are manipulated by crooked investors and are so risky because sometimes a few cents can mean more than a ten percent change. Options, including put and calls, are ways to make short term bets on the movement of a particular stock or index. Betting on short term movements is very dangerous and impossible to predict. And finally, flipping houses is another very risk investment. That’s because you typically use a short term loan to fix up a house and then resell it. However, if you hit a snag, buy a bad property, or the housing market collapses, you could quite easily lose all of your invested capital. These types of investments are the riskiest types. Of these, flipping houses is the least risky, but should only be attempted if you have enough capital to endure any hardships, and then it should be used only as part of your overall portfolio.
In conclusion, these are the types of investment risks that investors can choose from. Most people fall into the middle, and the next minority would be in the low risk categories. Have you figured out where you fit?