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The Reality of Investment Risk

When it comes to risk, here’s a reality check: All investments carry some degree of risk. Stocks, bonds, mutual funds and exchange-traded funds can lose value, even all their value, if market conditions sour. Even conservative, insured investments, such as certificates of deposit (CDs) issued by a bank or credit union, come with inflation risk. They may not earn enough over time to keep pace with the increasing cost of living.

What Is Risk?

When you invest, you make choices about what to do with your financial assets. Risk is any uncertainty with respect to your investments that has the potential to negatively affect your financial welfare.

For example, your investment value might rise or fall because of market conditions (market risk). Corporate decisions, such as whether to expand into a new area of business or merge with another company, can affect the value of your investments (business risk). If you own an international investment, events within that country can affect your investment (political risk and currency risk, to name two).

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There are other types of risk. How easy or hard it is to cash out of an investment when you need to is called liquidity risk. Another risk factor is tied to how many or how few investments you hold. Generally speaking, the more financial eggs you have in one basket, say all your money in a single stock, the greater risk you take (concentration risk).

In short, risk is the possibility that a negative financial outcome that matters to you might occur.

There are several key concepts you should understand when it comes to investment risk.

Risk and Reward. The level of risk associated with a particular investment or asset class typically correlates with the level of return the investment might achieve. The rationale behind this relationship is that investors willing to take on risky investments and potentially lose money should be rewarded for their risk.

In the context of investing, reward is the possibility of higher returns. Historically, stocks have enjoyed the most robust average annual returns over the long term (just over 10 percent per year), followed by corporate bonds (around 6 percent annually), Treasury bonds (5.5 percent per year) and cash/cash equivalents such as short-term Treasury bills (3.5 percent per year). The tradeoff is that with this higher return comes greater risk: as an asset class, stocks are riskier than corporate bonds, and corporate bonds are riskier than Treasury bonds or bank savings products.

Exceptions Abound

Although stocks have historically provided a higher return than bonds and cash investments (albeit, at a higher level of risk), it is not always the case that stocks outperform bonds or that bonds are lower risk than stocks. Both stocks and bonds involve risk, and their returns and risk levels can vary depending on the prevailing market and economic conditions and the manner in which they are used. So, even though target-date funds are generally designed to become more conservative as the target date approaches, investment risk exists throughout the lifespan of the fund.

Averages and Volatility. While historic averages over long periods can guide decision-making about risk, it can be difficult to predict (and impossible to know) whether, given your specific circumstances and with your particular goals and needs, the historical averages will play in your favor. Even if you hold a broad, diversified portfolio of stocks such as the S&P 500 for an extended period of time, there is no guarantee that they will earn a rate of return equal to the long-term historical average.

The timing of both the purchase and sale of an investment are key determinants of your investment return (along with fees). But while we have all heard the adage, “buy low and sell high,” the reality is that many investors do just the opposite. If you buy a stock or stock mutual fund when the market is hot and prices are high, you will have greater losses if the price drops for any reason compared with an investor who bought at a lower price. That means your average annualized returns will be less than theirs, and it will take you longer to recover.

Investors should also understand that holding a portfolio of stocks even for an extended period of time can result in negative returns. For example, on March 10, 2000, the NASDAQ composite closed at all-time high of 5,048.62. It has only been recently that the closing price has approached this record level, and for well over a decade the NASDAQ Composite was well off its historic high. In short, if you bought at or near the market’s peak, you may still not be seeing a positive return on your investment. Investors holding individual stocks for an extended period of time also face the risk that the company they are invested in could enter a state of permanent decline or go bankrupt.

Time Can Be Your Friend or Foe

Based on historical data, holding a broad portfolio of stocks over an extended period of time (for instance a large-cap portfolio like the S&P 500 over a 20-year period) significantly reduces your chances of losing your principal. However, the historical data should not mislead investors into thinking that there is no risk in investing in stocks over a long period of time.

For example, suppose an investor invests $10,000 in a broadly diversified stock portfolio and 19 years later sees that portfolio grow to $20,000. The following year, the investor’s portfolio loses 20 percent of its value, or $4,000, during a market downturn. As a result, at the end of the 20-year period, the investor ends up with a $16,000 portfolio, rather than the $20,000 portfolio she held after 19 years. Money was made—but not as much as if shares were sold the previous year. That’s why stocks are always risky investments, even over the long-term. They don’t get safer the longer you hold them.

This is not a hypothetical risk. If you had planned to retire in the 2008 to 2009 timeframe—when stock prices dropped by 57 percent—and had the bulk of your retirement savings in stocks or stock mutual funds, you might have had to reconsider your retirement plan.

Investors should also consider how realistic it will be for them to ride out the ups and downs of the market over the long-term. Will you have to sell stocks during an economic downturn to fill the gap caused by a job loss? Will you sell investments to pay for medical care or a child’s college education? Predictable and unpredictable life events might make it difficult for some investors to stay invested in stocks over an extended period of time.

Managing Risk

You cannot eliminate investment risk. But two basic investment strategies can help manage both systemic risk (risk affecting the economy as a whole) and non-systemic risk (risks that affect a small part of the economy, or even a single company).

  • Asset Allocation. By including different asset classes in your portfolio (for example stocks, bonds, real estate and cash), you increase the probability that some of your investments will provide satisfactory returns even if others are flat or losing value. Put another way, you’re reducing the risk of major losses that can result from over-emphasizing a single asset class, however resilient you might expect that class to be.
  • Diversification. When you diversify, you divide the money you’ve allocated to a particular asset class, such as stocks, among various categories of investments that belong to that asset class. Diversification, with its emphasis on variety, allows you to spread you assets around. In short, you don’t put all your investment eggs in one basket.

Hedging (buying a security to offset a potential loss on another investment) and insurance can provide additional ways to manage risk. However, both strategies typically add (often significantly) to the costs of your investment, which eats away any returns. In addition, hedging typically involves speculative, higher risk activity such as short selling (buying or selling securities you do not own) or investing in illiquid securities.

The bottom line is all investments carry some degree of risk. By better understanding the nature of risk, and taking steps to manage those risks, you put yourself in a better position to meet your financial goals.

8 High-Risk Investments That Could Double Your Money

When an investment vehicle offers a high rate of return in a short period of time, investors know this means the investment is risky.

Given enough time, many investments have the potential to double the initial principal amount, but many investors are instead attracted to the lure of high yields in short periods of time despite the possibility of unattractive losses.

Make no mistake, there is no guaranteed way to double your money with any investment. But there are plenty of examples of investments that doubled or more in a short period of time. For every one of these, there are hundreds that have failed, so the onus is on the buyer to beware.

Key Takeaways

  • Finding an investment that enables you to double your money is almost impossible and would certainly involve taking on risks.
  • However, there are some investments that might not double your money, but do offer the potential for big returns; while they provide risk, the risk is manageable, as they are based on fundamentals, strategy or technical research.
  • They include the Rule of 72, options investing, initial public offerings (IPOs), venture capital, foreign emerging markets, REITs, high-yield bonds and currencies.

The Rule of 72

This is definitely not a short term strategy, but it is tried and true. The Rule of 72 is a simple way to determine how long an investment will take to double given a fixed annual rate of interest. By dividing 72 by the annual rate of return, investors obtain a rough estimate of how many years it will take for the initial investment to duplicate itself.

For example, the Rule of 72 states that $1 invested at an annual fixed interest rate of 10% would take 7.2 years ((72/10) = 7.2) to grow to $2. In reality, a 10% investment will take 7.3 years to double ((1.10^7.3 = 2). If you have the time, the magic of compound interest and the Rule of 72 is the surest way to double your money.

Investing in Options

Options offer high rewards for investors trying to time the market. An investor who purchases options may purchase a stock or commodity equity at a specified price within a future date range. If the price of a security turns out to be not as desirable during the future dates as the investor originally predicted, the investor does not have to purchase or sell the option security.

This form of investment is especially risky because it places time requirements on the purchase or sale of securities. Professional investors often discourage the practice of timing the market and this is why options can be dangerous or rewarding. If you want to learn more about how options work, read our tutorial or sign up for our Options for Beginners course on the Investopedia Academy.

Initial Public Offerings

Some initial public offerings (IPOs), such as Snapchat’s in mid-2020, attract a lot of attention that can skew valuations and the judgments professionals offer on short-term returns.   Other IPOs are less high-profile and can offer investors a chance to purchase shares while a company is severely undervalued, leading to high short- and long-term returns once a correction in the valuation of the company occurs. Most IPOs fail to generate significant returns, or any returns at all, such as the case with SNAP. On the other hand, Twilio Inc. (TWLO), a cloud communications company that went public in June of 2020, raised $150 million at an IPO offer price of $15 a share.   In its third day of trading, Twilio was up 90 percent and by mid-December was up 101 percent. 

IPOs are risky because despite the efforts make by the company to disclose information to the public to obtain the green light on the IPO by the SEC, there is still a high degree of uncertainty as to whether a company’s management will perform the necessary duties to propel the company forward.

Venture Capital

The future of startups seeking investment from venture capitalists is particularly unstable and uncertain. Many startups fail, but a few gems are able to offer high-demand products and services that the public wants and needs. Even if a startup’s product is desirable, poor management, poor marketing efforts, and even a bad location can deter the success of a new company.

Part of the risk of venture capital is the low transparency in management’s perceived ability to carry out the necessary functions to support the business. Many startups are fueled by great ideas by people who are not business-minded. Venture capital investors need to do additional research to securely assess the viability of a brand new company. Venture capital investments usually have very high minimums, which can be a challenge for some investors. If you are considering putting your money into a venture capital fund or investment, make sure to do your due diligence.

Foreign Emerging Markets

A country experiencing a growing economy can be an ideal investment opportunity. Investors can buy government bonds, stocks or sectors with that country experiencing hyper-growth or ETFs that represent a growing sector of stocks. Such was the case with China from 2020.   Spurts in economic growth in countries are rare events that, though risky, can provide investors a slew of brand new companies to invest in to bolster personal portfolios.

The greatest risk of emerging markets is that the period of extreme growth may last for a shorter amount of time than investors estimate, leading to discouraging performance. The political environment in countries experiencing economic booms can change suddenly and modify the economy that previously supported growth and innovation.

REITs

Real estate investment trusts (REITs) offer investors high dividends in exchange for tax breaks from the government.   The trusts invest in pools of commercial or residential real estate.

Due to the underlying interest in real estate ventures, REITs are prone to swings based on developments in an overall economy, levels of interest rates and the current state of the real estate market, which is known to flourish or experience depression. The highly fluctuating nature of the real estate market causes REITs to be risky investments.

Although the potential dividends from REITs can be high, there is also pronounced risk on the initial principal investment. REITs that offer the highest dividends of 10% to 15% are also at times the riskiest.

While these investment choices can provide lucrative returns, they are marred by different types of risks. While risk may be relative, these investments require a combination of experience, risk management, and education.

High Yield Bonds

Whether issued by a foreign government or high-debt company, high yield bonds can offer investors outrageous returns in exchange for the potential loss of principal. These instruments can be particularly attractive when compared to the current bonds offered by a government in a low-interest-rate environment.

Investors should be aware that a high yield bond offering 15 to 20% may be junk and the initial consideration that multiple instances of reinvestment will double a principal should be tested against the potential for a total loss of investment dollars. However, not all high yield bonds fail, and this is why these bonds can potentially be lucrative.

Currency Trading

Currency trading and investing may be best left to the professionals, as quick-paced changes in exchange rates offer a high-risk environment to sentimental traders and investors.

Those investors who can handle the added pressures of currency trading should seek out the patterns of specific currencies before investing to curtail added risks. Currency markets are linked to one another and it is a common practice to short one currency while going long on another to protect investments from additional losses. Currency, or forex trading, as it is called, is not for beginners. If you want to learn more, check out our tutorial or take our Forex for Beginners course on the Investopedia Academy.

Trading on the forex market does not have the same margin requirements as the traditional stock market, which can be additionally risky for investors looking to further enhance gains.

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