When it comes to investing your hard-earned money, you obviously want it to grow. That’s really the whole point of investing as opposed to keeping it in the bank. But you also know that investing means that you can lose money, and you hate the idea of all that money you’ve saved suddenly disappearing.
So, how do you know which investments will help your money grow without subjecting it to too much risk? There’s no perfect answer, but this post will help you figure it out.
What follows is an investment riskometer that ranks the most popular types of investments from least risky to most risky so that you can find the perfect balance between growth and safety for your personal goals and preferences.
A Quick Primer on Investment Risk
Before we dive into the investment riskometer, there are a few big picture ideas that are important to keep in mind.
First, risk and return are inextricably linked in the world of investing. That is, just about any investment that offers higher expected returns comes with higher risk. You can’t get better returns without taking on more risk. (Though it’s worth noting that increased risk DOES NOT automatically lead to higher expected returns.)
Second, this investment riskometer – and the investment world in general – defines risk as variability in returns. The more the return from a particular investment fluctuates from year to year, the riskier it is.
But it’s important to understand that there are other risks as well. Inflation, for example, is a big risk over long time periods, and a “safe” investment that provides a small guaranteed return may actually face significant risk of losing real value by not keeping up with inflation.
Finally, there are a few simple ways to manage the overall risk of your investment porfolio, no matter which specific investments you choose:
- Emergency fund: Having an emergency fund in place reduces the risk that investment losses will leave you without the money you need to pay your bills.
- Asset allocation: Your overall asset allocation is the primary driver of your investment portfolio’s risk and expected return. The specific investments you choose are less important than your portfolio’s overall balance between stocks and bonds.
- Diversification: Diversification is the practice of spreading your money out over a number of different investments instead of putting it all into just a few, and it’s one of the only ways to decrease risk without decreasing expected return.
Focusing on those principles first and foremost will do more than anything else to keep you from taking on more risk than you’re willing to take.
The Investment Riskometer
What follows is a list of types of investments, ranked from least risky to most risky. But first, a few words of warning:
- This list is not comprehensive. These are by and large the most common investment categories, but there are many different types of investments not included on this list.
- This ranking is general, not definitive. The distinction between certain categories is small and you could easily argue for a different order.
- The future is unknown and just about any particular investment could lose more or less value than any other investment over any given time frame.
With that, I present the investment riskometer!
1. Savings Accounts
A good savings account offers FDIC insurance, a guarantee that your account balance will never decrease, and a known return, though the interest rate will rise and fall as market rates change.
The main risk is that inflation will likely outpace the interest rate you earn. This shouldn’t matter over short time periods, but it can have a big impact over long time periods.
2. Money Market Mutual Funds
Money market mutual funds are a lot like savings accounts. They pay a small interest rate that changes with overall market rates and your account balance will never fall.
The main difference is that money market mutual funds are not protected by FDIC insurance, which could matter in worst-case scenarios.
With a traditional certificate of deposit, you agree to lock your money in the CD for a set amount of time in exchange for a higher interest rate than what you can get from a savings account. The main risks are the penalties involved if you need to withdraw the money early and the fact that in most cases your interest rate will be fixed and will not increase if overall market rates increase.
You can also buy brokered CDs, which are easier to trade than traditional CDs but whose value can rise and fall with the market.
4. U.S. Treasury Bonds
U.S. Treasury bonds are generally considered to be the safest bonds in the world. The value will rise and fall, but they are fully guaranteed by the U.S. government.
5. Municipal Bonds
Municipal bonds are issued by states, counties, cities, and other municipalities. The main benefit is that the interest you earn is exempt from federal taxes, and in some cases exempt from state and local taxes as well. The risk level varies widely, though, and it’s important to do your due diligence before investing.
6. Investment-Grade Corporate Bonds
These are bonds issue by U.S. companies that ratings agencies have deemed to have a relatively low risk of default. There’s more risk than with Treasury bonds, but you may also earn slightly more interest.
7. International Treasury Bonds
Other governments issue bonds, too, and the risk level really depends on the overall characteristics of the country and its government. This is one area where diversification is particularly important so that you’re not too dependent on any single government.
8. High-Yield/Junk Bonds
High-yield bonds – also known as junk bonds – are bonds issued by companies that ratings agencies have deemed more likely to default. You can get higher interest rates, but that comes with greater risk that the bonds will never be repaid.
9. Large Cap U.S. Stocks
Large cap U.S. stocks are stocks issued by the biggest companies in the United States. This is essentially what the S&P 500 represents. Stocks always carry risk, but these are some of the most stable companies in the world.
10. Developed Market International Stocks
Stocks issued by companies from developed markets share many of the characteristics of U.S. stocks, with a little bit of extra risk. They can be a great diversifier, ensuring that you have money invested in companies across the globe.
11. Small Cap U.S. Stocks
Small cap U.S. stocks are issued by the smallest public companies in the United States. These stocks offer the potential for higher returns than large cap stocks, but they come with more risk because they represent younger, less established companies.
REITs – short for real estate investment trusts – allow you to invest in real estate without having to purchase individual properties. They can be a good way to invest in the real estate market in a way that’s more diversified and less labor-intensive than managing properties.
13. Emerging Market International Stocks
Emerging stock markets are generally smaller and less developed than other stock markets. Stocks issued by companies within these markets have the potential to provide superior returns, but they come with an increased level of risk.
14. Investment Properties
Buying individual investment properties can certainly pay off, but they are inherently undiversified. Each property you own represents a significant amount of money invested in a single asset, and it’s a costly asset to boot. That’s not to say that you should never buy investment properties, just that you should do so carefully.
15. Alternative Investments
There are many other alternative investments, from gold, to commodities, to peer-to-peer lending, to collectibles like art and fine wine.
As a financial planner, I generally steer clients away from investments like these. It’s hard to know what to expect and the costs can be significant. There is also often more risk involved than what’s presented up front.
Remember That Risk Is Relative
My hope is that the list above helps you understand a little more about the investment options available to you so that you can make more informed decisions when putting your own portfolio together.
But it’s important to remember that risk is not absolute. You have your own goals and your own preferences, and your particular risks will not be the same as everyone else’s.
Above all, remember that the purpose of investing is never to minimize risk or maximize returns. It’s simply to create and implement an overall investment plan that helps you reach your personal goals. Choosing the right mix of investments one part of that plan that can help you get and stay on track.
Matt Becker, CFP® is a fee-only financial planner and the founder of Mom and Dad Money, where he helps new parents take control of their money so they can take care of their families.