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How risk, reward & time are related

You may have heard it said, "No risk, no reward." But did you know that time can actually decrease your risk while increasing your reward?

POINTS TO KNOW

  • Different types of investments have different levels of risk.
  • The longer you keep your money invested, the better your odds of overcoming any down markets.
  • Your investment gains can grow exponentially over time as your earnings are compounded.

Investing: Risky business?

When some people think of investing, they focus on the potential for great rewards—the possibility of buying unknown stocks that increase in value many times over.

Other people focus on the risk—the possibility of losing everything in a market crash or on a bad stock pick.

Who's right? Well, it's true that all investing involves some risk. It's also true that investing is one of the best ways to increase the amount of money you have available to meet your goals (although an expectation of immediate riches is highly unrealistic).

In fact, there's typically a direct relationship between the amount of risk involved in an investment and the potential amount of money it could make.

Different types of investments fall all along this risk-reward spectrum. No matter what your goal is, you can find investments that could help you reach your goal without taking on unnecessary risk.

Time is on your side

Here's the secret ingredient that can make investments less risky: time.

Based on past history, if you invested in the stock market for 1 year, your chance of losing money would be greater than 1 in 4. But if you invested for 10 years, that number would drop to about 1 in 25—and after 20 years, to zero.*

Some caveats

If you invest in just a handful of stocks or in a bunch of stocks in the same industry, time won't necessarily make your portfolio any safer. Just ask someone who held Enron stock or e-commerce stocks for years, only to see their value vanish overnight.

The reason it works for diversified investment portfolios is that over time, there tend to be more "winners" than "losers." And the investments that gain money offset the ones that go bust.

Also, you have to leave your money invested the entire time. If you pull your money out when your balance has fallen and then start buying again when prices are back up, you'll just dig yourself into a hole.

The more time you have, the more you benefit from compounding

Not only can the passage of time help lower your investment risk, it can potentially increase the rewards of investing.

Imagine you place 1 checker on the corner of a checker board. Then you place 2 checkers on the next square and continue doubling the number of checkers on each following square.

If you've heard this brainteaser before, you know that by the time you get to the last square on the board—the 64th—your board will hold a total of 18,446,744,073,709,551,615 checkers.

No, we're not promising to double your money every year! But this principle—known as "compounding"—is important to understand: When your starting amount is higher, your increases are higher too. And over time, it can seriously add up.

As a rule of thumb, if your investments returned 6% annually, you would double your investment about every 12 years.

For example, if you earn 6% on a $10,000 investment, you'll make $600 in the first year. But then you start the second year with $10,600—during which your 6% returns net you $636.

In the 20th year of this hypothetical example, you'll earn more than $1,800—and your balance will have increased more than 200%.

Another caveat

If you take your earnings out of your account and spend them every year, your balance will never get any bigger—and neither will your annual earnings. So instead of making more than $20,000 over 20 years, you'd only collect your $600 every year for a total of $12,000.

If you instead leave your money alone, as you can see below, your "earnings on earnings" will eventually grow to be larger than the earnings on your original investment.

Leave your earnings invested and watch compounding go to work

This graph shows how earnings on earnings will increasingly grow over time if you leave them in your account

This hypothetical illustration assumes a $10,000 investment and an annual 6% return. The illustration doesn't represent any particular investment, nor does it account for inflation.

What's next?

The best way to make these concepts work for you is to build a diversified portfolio with the right level of risk.


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REFERENCE CONTENT

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Stock

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.

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Risk

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.

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Market

The trading of a universe of investments, based on factors like supply and demand. For example, the "stock market" refers to the trading of stocks.

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Portfolio

The sum total of your investments managed toward a specific goal.

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Diversification

The strategy of investing in multiple asset classes and among many securities in an attempt to lower overall investment risk.

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Earnings

The investment returns you accumulate on the savings in your account.

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Leave your earnings invested and watch compounding go to work

This graph shows how much you could earn each year, based on an investment of $10,000 and an annual return of 6%. Every year, you would earn $600 on your original investment. If you leave those earnings in the account, the earnings on your earnings will continue to grow. After 20 years, your "earnings on earnings" would give you an additional $1,300 a year, for a total of about $1,900 during that year.