The risk of different investment types
The 3 main types of assets all have different levels of risk and potential reward. You can mix them in order to lower your chance of losing money.
POINTS TO KNOW
- Of the 3 main asset classes, cash is the safest, followed by bonds and then stocks.
- Safer investments also have lower average returns.
- By mixing investments, you can get a balance of both stability and growth potential.
What are the 3 asset types?
Cash (short-term reserves) & money market funds
Main goal: stability. You probably won't lose money with these investments, but you won't gain much either.
Main risk: The rate at which you earn money could be lower than the rate of inflation.
Average return over time: 3.5% a year before inflation, 0.6% a year after inflation.*
Percentage of years with a negative return: 0%.
Bonds & bond funds
Main risks: Because bond prices and interest rates move in opposite directions, rising interest rates could push bond prices down. The bond's issuer could stop making promised payments or be unable to repay the principal.
Average return over time (for U.S. bonds): 5.5% a year before inflation, 2.5% a year after inflation.*
Percentage of years with a negative return: 16%.
Stocks & stock funds
Main goal: getting a larger return in exchange for a larger amount of risk.
Stocks can also be domestic or international. As with bonds, it's smart to consider holding both.
Main risks: Stock prices could drop for a variety of reasons, including poor performance of certain companies and concern about the economy. Dips in the stock market tend to be worse than in the bond market.
Average return over time (for U.S. stocks): 10.2% a year before inflation, 7.1% a year after inflation.*
Percentage of years with a negative return: 28%.
How does mixing investments lower risk?
As you can see, stocks, on average, have the highest potential return. Adding bonds tends to shrink the range of possible outcomes you could face every year—creating a lower opportunity for returns but also a reduced risk of loss.
If you have a long timeline (10 years or more) and a very high risk tolerance, you might be fine with an all-stock portfolio. But if you need your money in less than a year or you're very conservative, you might need to keep your money in cash.
If you fall somewhere in the middle, your portfolio should be made up of a variety of asset types, giving you a more moderate level of portfolio risk.
Adding bonds tends to lower both risk and potential return
Source: Vanguard. Best and worst calendar-year returns from 1926 through 2014. Stocks are represented by the Standard & Poor's 90 Index from 1926 to March 3, 1957; the S&P 500 Index from March 4, 1957, through 1974; the Wilshire 5000 Index from 1975 through April 22, 2005; the MSCI US Broad Market Index from April 23, 2005, to June 2, 2013; and the CRSP US Total Market Index thereafter. Bonds are represented by the S&P High Grade Corporate Index from 1926 to 1968; the Citigroup High Grade Index from 1969 to 1972; the Barclays U.S. Long Credit AA Index from 1973 to 1975; the Barclays U.S. Aggregate Bond Index from 1976 to 2009; and the Spliced Barclays U.S. Aggregate Float Adjusted Index thereafter.
A general rise in the prices of goods and services.
A moderate investment is neither very aggressive nor very conservative. Because risk and reward are related, a moderate investor can expect returns that are, on average, neither very high nor very low.
Usually refers to investment risk, which is a measure of how likely it is that you could lose money in an investment. However, there are other types of risk when it comes to investing.
Usually refers to common stock, which is an investment that represents part ownership in a corporation. Each share of stock is a proportional stake in the corporation's assets and profits.
A bond represents a loan made to a corporation or government in exchange for regular interest payments. The bond issuer agrees to pay back the loan by a specific date. Bonds can be traded on the secondary market.
The sum total of your investments managed toward a specific goal.
Income you can receive by investing in bonds or cash investments. The investment's interest rate is specified when it's issued.
A conservative portfolio is relatively safe from investment risk (although there's no guarantee it won't lose money). Because risk and reward are related, a conservative investor can also expect returns that are, on average and over time, lower than those of someone with a moderate or aggressive portfolio.
This chart shows the best and worst calendar-year returns for different asset classes. For a portfolio of 100% stocks, the best return was 54.2% and the worst loss was -43.1%. For a portfolio of 90% stocks and 10% bonds, the best return was 49.8% and the worst loss was -39.0%. For a portfolio of 80% stocks and 20% bonds, the best return was 45.4% and the worst loss was -34.9%. For a portfolio of 70% stocks and 30% bonds, the best return was 41.1% and the worst loss was -30.7%. For a portfolio of 60% stocks and 40% bonds, the best return was 36.7% and the worst loss was -26.6%. For a portfolio of 50% stocks and 50% bonds, the best return was 32.3% and the worst loss was -22.5%. For a portfolio of 40% stocks and 60% bonds, the best return was 27.9% and the worst loss was -18.4%. For a portfolio of 30% stocks and 70% bonds, the best return was 28.4% and the worst loss was -14.2%. For a portfolio of 20% stocks and 80% bonds, the best return was 29.8% and the worst loss was -10.1%. For a portfolio of 10% stocks and 90% bonds, the best return was 31.2% and the worst loss was -8.2%. For a portfolio of 100% bonds, the best return was 32.6% and the worst loss was -8.1%.
The profit you get from investing money. Over time, this profit is based mainly on the amount of risk associated with the investment. So, for example, less-risky investments like certificates of deposit (CDs) or savings accounts generally earn a low rate of return, and higher-risk investments like stocks generally earn a higher rate of return.