If you have money to invest and you are looking for an investment that carries no risk, you are likely to be disappointed. That’s because any investment comes with a variety of risks, which means there is really no such thing as a risk-free investment. Of course, the degree of inherent risk varies and some investments are less risky than others. That’s why there are low-risk and high-risk investments, but certainly not risk-free investments.
Investments are Inherently Risky
In investment speak, “risk” typically refers to the variability of return. If you invest in a stock, for instance, you have no guarantee that you will get back the amount you invested, let alone make a profit. You may or may not get a dividend payment, depending on how the management decides to use any cash it generates. This makes stocks a high-risk investment. On the other hand, you could also hit the jackpot and get a really big payout.
There are also low-risk investments such as government bonds, FDIC-insured savings accounts, and certificates of deposit. Here, the risk you are subject to is not so much that you lose your principal as that you get a return that, after adjusting for inflation, is subpar. If you don’t see any real growth in your return, this will cut into your purchasing power. Thus, the so-called risk-free rate associated with certain government securities only provides for a basic return. There are also government securities, such as the Treasury Inflation-Protected Securities, or TIPS, that have a payout that is tied to inflation. However, you will not see any growth in your return beyond that. You will be able to preserve your basic purchasing power, but you may face the risk of not being able to meet your long-term goals, such as saving for retirement.
Variety of Risks
If you decide to put your money in stocks, corporate bonds, real estate, derivatives, or any other type of investment, there are a variety of risks to watch for. There is always the risk that government policies will change, impacting any particular industry negatively. And consumer tastes could change, which could cut into the demand for a product.
There is also the specter of currency risk, which means that the value of your investment could suffer as foreign exchange rates change, if you invest in a company that has overseas exposure. And bonds are subject to interest-rate risk, which means that their market value will be impacted as interest rates go up or down. Even with real estate investments, you might have to take on unanticipated maintenance costs that cut into your return. And, as happened during the US housing market downturn that started in 2006, real estate prices could also go down.
Diversification Can Help
While investments are risky, one way of cutting down on the risk is through diversification. You could even invest globally. Thus, if you own a portfolio made up of a variety of investments, you can cut down on your risk somewhat. When one investment does badly, it is likely to be balanced out by another that does well. This way, you are likely to be less subject to sharp swings in the value of your portfolio.
Gauge your Risk Tolerance
While diversification does help to some extent, in recent years various types of investments and even markets worldwide have become more tied together than before. Thus, during the 2007 to 2008 financial crisis, all sorts of investments were impacted negatively as global markets moved down together. Considering that diversification can only go so far to cut down on risk, another way to handle risk is to gauge your risk tolerance and invest accordingly. If you are the sort of person who can’t sleep at night during episodes of market volatility, you have a low tolerance for risk. You might want to cut down on your high-risk investments.
The Bottom Line
Investments are subject to risk and come with no guarantee. Some are less risky than others and you can manage your risk exposure. However, steer clear if someone touts a “risk-free” investment that offers a high return.