Understanding the Investment Risk Ladder

All assets have an underlying level of risk. For instance, imagine that you own 100 shares of XYZ company valued at $50 per share ($5,000 total). Word breaks out that another organization will acquire XYZ company. The share price skyrockets to $125 per share – a colossal 150 percent increase. On the other hand, XYZ may announce a material misstatement in its prior-year financial statement, causing the stock price to plummet. You’re not as likely to see drastic fluctuations with other assets, such as cash and bonds. Why? Cash and bonds are at the bottom of the investment risk ladder ­– a graphical representation of asset categories. The higher an asset’s position on the investment risk ladder, the higher the risk. At the same time, assets positioned towards the top can yield greater returns.

If you Google “investment risk ladder,” you’ll come across multiple variations. For example, there are ladders for bonds, equities, and physical assets. However, beginner and intermediate investors should understand the fundamental investment risk ladder that consists of the following (ordered from least risky to riskiest):

Cash Deposits

Leaving cash in a bank is virtually risk-free. You’re protected with $250,000 worth of FDIC insurance if the bank goes under. Those with more than $250,000 in cash should spread their funds out between multiple checking and savings accounts. Many individuals have a cash emergency fund that equals three to six months’ living expenses. In addition, some people keep cash in the short-term when they’re saving for upcoming purchases, such as a vehicle or home. It’s also an excellent idea to explore debt paydown strategies if you’re sitting on extra cash, such as the debt avalanche method and debt snowball method.

There are some downsides if the majority of your assets are cash. The average interest rate is roughly 0.06 percent, so you shouldn’t expect to see any significant interest deposits. Moreover, you miss out on potential returns that you could gain in riskier asset classes, such as ETFs and individual stocks. However, it’s a double-edged sword – you can make a lot of money investing in stocks, and you can also lose a lot. Therefore, many financial advisors recommend that young adults put more money in stocks as they can recoup losses later in life.

You also can’t hedge against inflation when you keep your money in cash. For instance, inflation in the United States jumped to 7.5 percent in January 2022 – one of the highest figures in the last four decades. If you only kept cash in savings and checking accounts since January 2021, you would have lost over seven percent of your purchasing power by January 2022.

Fixed Interest Securities

After cash, fixed interest securities hold the second-lowest amount of risk on the ladder. Fixed interest securities include bonds and debentures. Many individuals buy bonds directly from the U.S. Treasury or invest in them through an index fund, such as Vanguard Total Bond Market Index Fund Investor Shares (VBMFX). There are various bonds, including corporate, U.S. savings, and municipal bonds. Investors generally see U.S. bonds as almost risk-free because the chance of the United States defaulting on its debt obligations is extremely rare.

You shouldn’t expect a bragworthy return on investment given bonds’ relatively low level of risk. For example, the current U.S. 10-Year Government Bond interest rate is 1.76 percent. Nevertheless, you’ll earn more money investing in bonds compared to a traditional savings account. It’s also common for people to gradually shift their investments from bonds to stocks as they get closer to retirement. This shift helps mitigate risk since they don’t have the time to regain losses if the stock market were to tank.

Mutual Funds

A mutual fund enables investors to mitigate risk by investing in a wide variety of financial instruments. Money managers spearhead mutual funds and hand-select the fund’s assets based on market analysis. Each mutual fund has a prospectus that outlines its objective. Gains and losses are split amongst shareholders based on their respective shares of the fund.

The four most common types of mutual funds consist primarily of:

  • Stocks
  • Bonds
  • A blend of stocks and bonds
  • Money market funds

Many large investment companies allow their customers to purchase mutual funds, such as Vanguard and Fidelity. Most investors shoot for a long-term return ranging from four to five percent.

Exchange-Traded Funds (ETFs)

Exchange-traded funds (ETFs) are similar to mutual funds in that they enable individuals to diversify their investments. For example, Vanguard Total Stock Market (VTI) is a large-bended ETF that tracks the CRSP US Total Market Index. Investors can also gain international exposure through ETFs and increase their exposure to specific industries, such as real estate. You can purchase ETF shares through a personal investment account, 401(k), and IRA.

At first glance, it may seem like ETFs, and mutual funds are the same thing. Although they have some commonalities, there are a few key differences. You can buy ETFs throughout the day, but you can only purchase a mutual fund at the end of the business day. In addition, ETFs tend to have lower fees compared to mutual funds.

Shares of Individual Stocks

Individual stocks fall on the top of the investment risk ladder. You can see enormous returns with individual stocks, but you can also suffer heavy losses. Also, purchasing individual stocks often requires more research and a more significant time commitment. Stocks can tank if companies don’t meet their earnings targets. At the same time, a stock can catapult if news breaks that another company will acquire the organization.

You can hedge the risk associated with individual stocks by diversifying your portfolio. That is, don’t invest heavily in just one sector, such as FAANG companies. Avoid putting all your eggs in one basket by purchasing the stocks of companies in various industries.

A Final Glance

The investment risk ladder is a fundamental concept that every investor should understand. Every asset carries some risk, and not recognizing that could lead to financial losses. Before you take a stab at investing, be sure to check out our debt payoff software. We have the best app to help pay off debt, which will free up more cash for investment opportunities!

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