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| The Tradeoff Between
Investment Risk and Return: Risky Business |
| On a game show,
there's usually a point where the contestant has
a choice: Play it safe and take home the money they've
already won, or risk it all to win an even greater
amount. While not a game show, investing also involves
taking risks to make money. |
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| Each kind of investment–stocks,
bonds, cash, and so on–has different levels of risks.
But one thing is true for all of them: The riskier
the investment, the higher the potential returns. That makes sense. The more danger you put
your money in, the more you should expect to earn
for taking the extra gamble. So naturally, lower-risk
investments such as bonds earn less than higher-risk
investments such as stocks. |
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| The basic question in investing,
then, is how do you divide your money to get good
returns in the long run without taking risks you
can't handle in the short run?
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| If you stick most of your money in cash,
for instance, you'll see not only that the range of expected
results–the difference between the typical result and the "worst
case" result–is small, but that you can't hope to
make much money. |
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| On the other hand, putting everything in more-risky
stocks increases both your expected payoff and your possible
loss or shortfall. |
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| One thing to consider as you try to determine how much risk to assume is your risk capacity, your investment objective, and your time horizon to that objective. Your risk capacity is a function of your age. The younger you are, the more risk you can assume. That's because you have many more years to recoup any losses. The amount of risk you assume also should be a function of your time horizon to your objective, such as retirement, buying a new home, or funding a child's college education. If you have many years before you plan to retire, for instance, it might be worth assuming more risk. |
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