When it comes to investing, knowing how much risk you are willing to take is critical. Many people new to investing want something that is safe, but will provide a large rate of return. Don’t we all.
Managing the amount of risk you take with your investments starts with understanding how much risk is inherently in your investment options. Once you understand how much risk you are taking with each dollar invested, you can then begin to think of how you can spread your dollars across the risk levels so you are able to comfortably achieve your financial goals.
In the 5 different risk levels below, 1 being risk-free and 5 being very risky, you can start to think about how to use different risk levels to achieve different goals. If you have a financial goal 3 years away, you should stay in the risk level 1 or 2 area. On the flip side, if you are saving up for retirement that is 30 years away, you can look to risk levels 4 or 5. Historically, the more risk you take in your investments, the more short term fluctuations that may occur. Be sure to know your investment risk levels before investing.
Risk Level 1 - Safety
These are the safest possible investments, which are backed by the US government, large banks, and/or insurance companies. Included in this category are Treasury Bonds, certificates of deposit, bank savings accounts, Money Market accounts, fixed annuities, and TIPS (Treasury Inflation-Protected Securities).
With low current interest rates, these investments may not provide a large rate of return. These investments should purely be looked at for the safety they provide.
Risk Level 2 - Income and Safety
Here we have investments that are not backed by the US government, but the guarantees they give up also allow for a slightly higher rate of return. Included in this category are municipal bonds, short or intermediate term corporate bonds, or TIPS mutual funds.
These investments will fluctuate in value more than a risk level 1 investment, but also may provide more investment income each year.
Risk Level 3 - Income
With the low interest rates I mentioned before, moving up the risk scale is one way to obtain higher levels of interest income. Since more risk is being taken on, you will expect to receive a higher rate of return. In this category, we find investments like long-term corporate bonds, conservative asset-allocation mutual funds, international bond funds, and “balanced” mutual funds.
This category of risk may be appropriate for retirees searching for additional income, while still having a long investment horizon through retirement.
Risk Level 4 - Growth
For young investors with long time horizons, it is generally a good approach to stomach short-term fluctuations for long-term growth. In the growth category, we find investments such as stock and equity funds, growth-and-income funds, and international equity funds. One other type of investment in this category would be a mortgage-free real estate investment property (not your home).
Growth investing has a goal of outpacing the rate of inflation to take advantage of long-term compound interest.
Risk Level 5 - Aggressive Growth
If you have your financial house in order - meaning you don’t carry any unnecessary debts, have an appropriately sized emergency fund in place and can handle recessionary times - you may turn to aggressive growth investments. At risk level 5, we are including investments like individual stocks, leveraged real estate investment property (with a mortgage), small-business ownership, hedge funds, private equity, and limited partnership investments.
Each of these types of investments carry large amounts of risk that are only suitable for those individuals with substantial outside wealth and understand the investment may possibly go down to zero.
Risk Level X - Gambling Luck
Powerball tickets, slot machines, cryptocurrencies. Good luck.