INB - Investment Risk and Return Lesson

Investment Risk and Return Lesson

A standard test for measuring your risk tolerance is asking yourself "How much of an investment can I stand to lose before I lose sleep over it?" Would you lose sleep over the smallest loss? Then you are risk averse. If you can handle substantial risk without losing sleep, you are probably a risk taker. In terms of investment, risk is the possibility of losing your original investment, while return is the possibility that your original investment will increase. Risk and return are directly related. The higher the risk, the higher the possible return. The lower the risk, the lower the possible return.

Risk tolerance is personal. Some people are, by nature, risk takers and have an easier time dealing with the possibility of loss than those who are risk averse. A standard test for measuring your risk tolerance is asking yourself "How much of an investment can I stand to lose before I would lose sleep over it?" Would you lose sleep over the smallest loss? Then you are risk averse. If you can handle substantial risk without losing sleep, you are probably a risk taker.

Emotional well-being is only a part of your risk tolerance picture, however. Two other factors weigh in heavily on your tolerance level: the amount you can afford to lose and your time frame. Do you have financial assets that will allow you to lose a substantial part of your investment and still not wreck your financial well-being? If so you can be a little more tolerant when it comes to risk. On the other hand, if losing any money would put your financial status in jeopardy, then you need to be risk averse. Also, if your time horizon stretches many years into the future, you can be more risk tolerant than if it is only a year or so away because you will have the opportunity to make-up any losses in the long run.

Investment Pyramid

We have learned that some investments are riskier than others. View the investment pyramid below to where different types of investments fall in the risk/return relationship.

Types of Investments: Decrease Risk--> Decrease in Return Increase in Risk, Increase in return

In addition, to these broad categories of risk, there are specific risks that an investor needs to be aware of. Some are systematic and can affect all investments; others are unsystematic and affect only certain investments. View the tabs below for definitions and examples of these specific risks.

Self-Assessment

Can you match these scenarios to the type of risk they represent?

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