A world of risks
Stocks are the most popular types of investments, with 52% of Americans invested in the market either through individual securities or mutual funds, ETFs or similar investments.2 Millions of Americans also own bonds, through mutual funds or as individual securities.
Despite their popularity, stocks and bonds carry multiple risks.
Among the risks stock owners face:
- Market risk: the risk that the overall market will drop
- Sector risk: the risk that the industry or market your stock is in will drop
- Economic risk: the risk that the economy will slump and drag down the stock market
- Individual stock risk: the risk that your specific stock will encounter difficult times and drop in value
- Geographical risk: the risk that the country or region you are invested in will hit hard times driving down the price of stocks in that market.
Fixed-income investments, such as bonds, also carry a variety of risks, such as interest-rate risk. If interest rates rise, typically the market value of many fixed-rate bonds tends to drop because investors can buy similar bonds with higher rates, reducing the attractiveness of the older, lower-yielding bonds.
You may be able to minimize interest-rate risk by investing in very short-term bonds or notes, but they typically pay a very low return, which would open you up to further inflation risk. You might avoid inflation risk by investing in high-yield bonds, but, again, you face interest-rate risk as well as credit risk, which is the risk that the bond may default and become worthless.
Why risk it?
Investors often choose to take on risk because over time the rewards of many investments have tended to outweigh the risks.
Despite all of its volatility, the S&P 500® index has grown by an average of more than 11% per year over the past 50 years (through 2018), while 10-year U.S. Treasury bonds have provided an average annual yield of about 7.0%.3 While past performance may not be indicative of future returns, those historic returns easily outpaced the average annual rate of inflation, which has been about 4% over the past 50 years.4 (The S&P 500® Index is a market-cap weighted index that represents the average performance of a group of 500 large-capitalization stocks.)
Reaching your goals may require risk
If you have ambitious savings goals, taking on risk may be one of the main avenues to achieving those goals.
Let’s say you hope to retire in 30 years, and after calculating your anticipated retirement expenses and factoring in the impact of inflation you determine that you’ll need about $2 million for retirement. (See: How Much Will You Need to Retire?)
To reach $2 million with no risk and no return on your savings, you would need to save $66,667 per year ($5,556 per month) for 30 years, which could be out of reach for most Americans.
By taking on some investment risk, you may still be able to reach your goal while saving significantly less each month.
With a relatively conservative approach to investing that earns a long-term return of 5% per year (after expenses), an investment of just $2,500 per month would grow to $2.09 million after 30 years (see graph below).
As the table below shows, more than half of your total of $2.09 million would come from the return on your investment. Your total amount invested during that period would be $900,000 with the remainder, $1.19 million, coming from your investment returns.