Retirement plan decisions made easy
Drill Down: Risk of an Individual Investment
Risk is the amount by which your actual outcome will vary from your expected outcome. (Those of you with a statistics background will recognize this as the definition of “standard deviation.”)
If we toss a coin ten times, we expect that heads will come up five times out of the ten. But we won’t be too surprised if heads actually comes up four or six times, instead of exactly five times. That is standard deviation (or “risk” for our purposes) means—the difference between expected and real outcomes.
In terms of investments, if we put $100 in a savings account at the bank, earning three percent interest, we darn well expect to have $103 in a year’s time. There’s no risk, meaning that we don’t expect a penny more or a penny less.
If, instead, we bought a 10-year bond paying five percent interest, there’s a bit of risk. In a year’s time, we’ll most likely have five dollars in interest payments, unless the company that issued the bond has gone bankrupt. But the value of the bond may not be $100 in a year’s time. Perhaps the market now sees this bond to be risky, and therefore won’t pay $100 for it. Or on the happy side, perhaps interest rates have gone down, in which case this old bond that still pays five percent is even more valuable than when you bought it. As there is a fair chance that the total return on the bond won’t be exactly five percent, the bond has risk.
Risk, in investment terms, is about upside possibilities as well as downside. You can buy a particular bond expecting a five percent return, and if it turns out to return ten percent in a year, you’re happy. That happiness can only result from taking on risk.
When we buy a share of stock, we’re taking on even more risk than we would be with a bond. Most of the total return of the stock is due to a change in the stock’s price, and in one year’s time that price may change dramatically, either higher or lower. You may have gone in with an expectation that the stock will return about ten percent, but the reality is that you have no guarantee as to what your actual return will be. In short, the less sure you are of what your future return will be, the more risk you have.
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Lesson 1: What the Heck is a 401k, and What’s So Great About It?
Lesson 2: Contributions to Your 401k
Lesson 3: Investments “Cook Book” Approach
» Lesson 4: Investments: How Investments Work
Lesson 5: Loans and Hardship Withdrawals from Your 401k
Lesson 9: Your 401k, Your Other Assets, and Your Life
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