We all know that making money is influenced by the level of risk you take. If you take on a low level of risk then your money is protected but your returns are very limited. On the opposite end, if you take on a lot of risk you could easily double or triple your money, but also have the risk of losing it all. In finance, this is called the risk versus return tradeoff. Each person has a different risk tolerance and that tolerance for risk is offset against their hunger for return. People that are less averse to risk tend to invest in riskier assets and people that have low tolerance for risk tend to invest in safe assets. Over time, many people move from risk takers to risk avoiders, and many people’s level of risk changes over time and based on their economic situation. During good times people take on more risk and during bad times, people get scared and take on less risk.
This post highlights the various levels of risk and the degrees of risk associated with each asset category.
- Savings Account. Deposits in a simple bank account is 100% insured by the FDIC and has almost no risk. You can also get a small return if the account offers interest.
- Money Market Funds. Investments in money market funds are very low risk and can also provide a small amount of return. Money market accounts can invest in taxable or tax-free investments and provide lots of liquidity.
- CDs. Certificates of Deposits typically provide a higher rate of return than the previous investments but you have to hold them to maturity, so you have the risk of missing out on higher interest rates and also have to pay a penalty if you sell them before they mature.
- Treasury Bills. Investing in government securities is medium risk. Although there is not much risk of default, you do face the risk that interest rates will change. When interest rates change the value of the treasury bill or treasury bond changes in the opposite direction.
- Muni Bonds. Muni bonds are also medium risk. They are slightly riskier than treasury bonds because they are not backed by the Federal government, but they are still backed by the issuing municipality. These bonds are less risky than corporate bonds because they are backed by local and state governments that have the power to raise taxes to pay the loans. Also, most of them are insured by third parties, which also reduces the risk.
- Corporate Bonds. Corporate bonds range from high quality / low risk to low quality (junk bonds) and high risk. Most corporate bonds fall somewhere in the middle. Risks in these bonds come from interest rate risk, credit quality risk, and default risk.
- Diversified Stocks. A diversified stock portfolio has medium to high risk and also offers higher returns than bonds (historically at least). While stocks have always increased in value over time, there have been 10 year periods with almost no growth.
- Undiversified Stocks. Investing in individual stocks is considered high risk. Kind of like putting all your eggs in one basket, the value of any individual stock is risky. Of course the risk depends on the quality and stability of the underlying company.
- Speculative Stocks. Not all stocks are created equally. Some are much riskier than other. For example, biotech companies often either are successful or go out of business depending on whether they create a successful drug. Buying stocks in speculative companies is considered high risk.
- Stock Options. Stock options are used to bet on whether a stock goes up or down. Over time a stock option expires and if your bet was not realized then your stock option will be worth zero. With that said, if your bet is right you can make multiples in return.
- Derivatives. There are lots of derivative based ways to make money. These include stock options from above, as well as other speculative investments such as contracts for difference (CFDs) and Spread Betting. Derivatives often use leverage to magnify returns and are extremely risky.
- Betting. If you don’t want to wait around for investment returns, and you seek the thrill of instant losses or returns, you can always try gambling. Although the house will win over the long term, you can still make money with the right combination of skill and luck. Like most of the investments above, you can bet online at Royal Vegas online casino traditional table games.
- Lottery Tickets. These are so speculative that the chances of making significant money are usually greater than one in a million. The good thing is that you only lose the amount the ticket costs. And sometimes day dreaming about winning is worth the price of admission.