Any time an investor is deciding where to put her money, she has to think about two things. One is risk, meaning the chance she will lose some or all of the money invested. The other consideration is return. Return is the amount of profit you expect to make if the investment does what you hope it will. Balancing risk against return is at the core of good investment decisions.
Risk and Return
The basic reason savings in a bank are safer than stocks and bonds is that the Federal Deposit Insurance Corporation insures deposits. Stocks and bonds aren’t insured, so there is always at least some risk of losing the money. Risk and reward go together in investing. The potential returns on bonds and stocks are much higher than for bank savings, but the trade-off is risk.
How Deposit Insurance Works
FDIC insurance covers bank deposits up to $250,000. If anything happens to the bank, the FDIC makes sure you get your money back. The limit applies separately to the deposits in each bank where you have accounts and to accounts in different “ownership categories.” Examples of ownership categories are single-owner accounts, joint accounts and some retirement accounts. Suppose you have accounts in two ownership categories at two different banks. You could have $250,000 in each ownership category at each bank for total insured deposits of a million dollars.
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The Risks of Bonds
Bond risk falls somewhere between that of bank savings and stocks. Bonds represent borrowed money. The government or corporation that issued them is obligated to pay it back at maturity. Maturity is the time until the debt is due to be repaid. If the issuer can’t meet this obligation, the investor could lose his money. To help investors, bonds are rated according to their default risk, with AAA and AA being the safest. But investors face another danger called interest rate risk. Bond prices can fall because market interest rates go up. This happens because the bond’s fixed interest rate becomes less attractive and investors flock to higher-paying new issue bonds. An investor may have to choose between holding a bond until maturity to get his money back, or selling at a loss and moving the money into a better-paying bond or other security.
The Risks of Stocks
The price of a stock is determined by how much people will pay for it. If a company does well, the price will probably go up, and the investor makes a profit. If the company runs into problems, or the economy sours, prices may fall. Companies are not obligated to redeem shares of stock as they must with bonds. There are two major risks investors face with stocks. Volatility risk means the stock price normally goes up and down. If you sell shares after a price drop, and the stock eventually rebounds, you lose money needlessly. But there’s also a permanent price risk. The company may go into a decline and never recover -- and the stock price tanks along with the firm’s fortunes. Successful investors learn to assess a company’s future prospects to decide if a fall in stock price is due to volatility or if it signals a permanent problem -- and they won’t always be right, hence the risky nature of stock investing.
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