Investing Basics: The Risk/Return Tradeoff

When it comes to investing, most people want to immediately turn to where to put their money.  We need to start at a much more basic level. 

Suppose I have a choice between two investments:

• Certificate of Deposit (CD) insured by your bank

• S&P 500 index fund

The index fund is considered riskier than the CD.  It is not insured.  Because it contains all the stocks in the S&P 500 index, its value fluctuates daily.  I expect to earn a higher return than on the CD to compensate me for this extra risk.

Suppose I expect to earn an 8% return on this fund over the long-term.  My actual return may differ from 8%:

• In Year 1, I earned 5%.

• Year 2 was great – I made 20%!

• I lost 1% in Year 3.

• If I held this investment for these three years, I will have averaged 8% a year.

The riskier the asset, the more my actual return will deviate from my expected return.

This deviation can be a real benefit, like in Year 2 when I earned 20%.  But it can also hurt, like in Year 3 when I lost 1%.

Would you be able to handle the fluctuations in actual returns?  If not, this investment is too risky for you.

Now you are ready to invest. Listen to my video Taking the Mystery Out of Investing to learn how to make good investment choices.