Risk is unavoidable if you want to invest in the financial markets. You may want to maximize risk for the biggest potential payout, or you may want to minimize risk to play it safe and protect your assets. Either way, understand the inherent risk of each asset class and weigh it against your age, goals and resources. Once you understand the risk factor of a potential investment, you can first make a smart decision about what works best for you.
The big investmentactive classincludes savings accounts, savings bonds, stocks, debt, derivatives, real estate, and hard assets. Each has a different risk/reward profile.
Here's an overview of these asset classes and what they represent in terms of risk.
Key learning points
- Understanding risks, including those associated with investing in the major asset classes, is important research for any investor.
- In general, CDs, savings accounts, cash, U.S. savings bonds, and U.S. Treasury bonds are the safest options, but they also offer the lowest returns.
- Corporate, municipal, state and federal bonds have different levels of risk that investors should consider, but are generally much riskier than savings bonds.
- Stocks, including mutual funds or exchange-traded funds (ETFs) that track stock indexes, are also risky.
- Futures and options are both complicated and risky, but they also offer unique opportunities for big returns – a risk/reward scenario that investors must weigh.
- Commodities are risky, but a commodity-focused investment fund or ETF can offset some of the risk.
CDs and other safe havens
The safest investments are savings accounts and certificates of deposit (CD), which are protected by Federal Deposit Insurance Corporation (FDIC) regulations. These investments are the safest asset class available.
Cash,US savings bondsand US government bonds are almost equivalent. They all have similar risk and the interest they offer is zero or negligible.However, for accounts that are larger than what FDIC regulations allow, they are the closest they come to being guaranteed.
Tradeable debt and equity are risky
Marketable debt is risky. Although these instruments are bonds, they are quite different from their savings bond peers. Corporate, municipal, state and federal bonds have different levels of risk. Rating agencies such as Standard & Poor's and Moody's publish detailed informationthe reportand provide assessments of companies' ability to service debt problems.
Stocks and stock-based investments such as mutual funds, index funds andexchange traded funds(ETFs) are risky because open market prices fluctuate every day.Absorbing regular losses in a controlled and disciplined manner is essential to any stock trading plan. Successful risk management is key to any equity investment method or system.
Understanding the risks of each asset class is essential in portfolio planning; however, these risks can still vary by individual investor when age, objectives and investable income are taken into account.
Derivatives are risky and complicated
Derivatives are risky and can be difficult to understand, which is a risk in itself.Futures and opportunitiesare quite complex and investors can suffer significant losses in each of them. However, derivatives also offer unique profit-making opportunities, which smart investors have made large amounts of capital by exploiting. Continuous research and the implementation of a sound plan are essential to managing the risks associated with derivatives trading.
To limit the risk of purchasing commodities directly, an investor can consider a commodity-focused mutual fund (ETF).
Gold, silver and everything that glitters
Commodities such as gold and silver can be owned through futures.Some gold investors own gold coins as a hedge against political instability or currency devaluation. While such an effort may be based on proper planning, the value of gold bullion has varied greatly during periods of political instability throughout history.Commodities are risky.
