Last time, I talked a little about risk. I wanted to expand a little more on this because risk is a concept that underlies much of investing. I think that people generally understand what risk is, but not how it affects different asset classes as well as the decisions an individual should make when investing.
There are different types of risk, but here I want to start off by talking about the basic risk-return issue, which, as I stated before, is that if a person invests in a risky asset, meaning that there is an increased chance they could lose part or all of their investment, that person would demand a higher return to compensate for that risk. This is true for any asset class. The basic “risk free” investment is U.S. federal government bonds, because there is almost no chance that the U.S. government will default on its obligations. If the U.S government does default, the economic/social/political situation would probably be so bad that basic survival would probably be a little more important than the return on your investments.
Other types of bonds are generally at the lower end of the risk spectrum, although you would expect that bonds issued by financially challenged entities would demand a premium. Stocks are generally more risky than bonds, although stocks also vary in risk, from large, established companies with relatively consistent earnings to small start-up companies that promise explosive growth but could also go under just as easily. If a risky investment does not provide the necessary return to justify the risk, then the investor can either switch to an investment that would provide the return, or put their money in a lower risk investment that also provides a lower return.
Evaluating this type of risk, and how a specific investor would respond to risk, is the first step of developing a suitable portfolio. Someone who does not like risk should not invest in highly speculative stocks, while someone who could tolerate large changes in stock prices in seeking a large return should not invest solely in government bonds.
Next up: diversification and modern portfolio theory…
