Risk and Return
As we have discussed the various types of investments, you may have noticed how some investments have the potential to earn more than others. This is no accident; it involves the relationship between two investment features: risk (how secure the investment is) and return (how much you can potentially earn). In general, the riskier the investment, the higher the potential payoff. Simply put, higher risk investments generally have higher returns because you face a greater chance of losing your investment. For instance, investing your money in a savings account that is insured by the government and that offers a steady rate of interest while keeping the principal intact has very little risk, but the yield is likewise low—typically about 2%. Conversely, investing in speculative stocks provides little to no protection from risk. You could lose every penny you put in, but the investment could yield as much as a 16% return or more.
If you want to increase your rate of return on an investment, you'll have to assume more risk. If you want protection from risk, you'll have to sacrifice some growth. Your investment goal should be to achieve the greatest possible growth for the given level of risk you are willing to take. The worksheet that follows can help you determine your risk tolerance level. Keep in mind that the worksheet is just a guideline to determine your risk profile. Your risk tolerance level is not a one-time thing; it can and will change over time, varying over the course of your life and different life events. For example, a person in his or her 20s can, and should, put their retirement funds on a vehicle heavily weighted in stocks, a riskier investment. But as the same individual ages, they should gradually shift the balance so that, when they are in their 50s and 60s, their retirement funds consist primarily of bonds, a safer investment. Take the following exercise, perhaps as a baseline, if you do not know what your risk tolerance level is. This is an exercise that should also be taken by your partner or anyone else who participates in your financial decision process. It is important that you understand one another's scores on this all-important measure.