All About Investing
Young Fools
March 25, 1998
Risk and Return
Before you try to evaluate and compare different types of investments, you need to understand what risk and return are. Risk and return are involved in every step of investing, as they are in parts of life.
When we talk about "risk" here, we're talking about how safe your money is. "Return" refers to how much your money grows (or shrinks).
Risk and Return are the cornerstones of investing. Think about a lottery for a minute. You can buy a ticket for only a dollar. And you might win millions of dollars, right? It might sound like a good thing. But a lottery ticket is a very risky investment. Odds are, you will not win. In fact, the odds are very, very high that you will not win. And what do you lose? Part of your dollar? Half of it? No -- you lose it all. You will probably lose 100% of your money. If, though, against incredible odds, you win, your return will be very high -- lots of money. So a lottery ticket is a high-risk/high-return kind of investment.
Compare the lottery ticket to a savings account at a bank and it's like night and day. You have no chance of losing your $100 in the bank -- unless aliens take over earth or the United States ceases to exist. The federal government guarantees, or insures, your money up to $100,000 in most banks. And if the bank says it will pay you 5% interest, you can be pretty darn sure it will. So there's really no risk at all. But your $100 will never turn into $1 million in the bank. A bank account is a low-risk/low-return investment.
You can see how important it is to consider both risk and return. Maybe you're also thinking that neither of these options looks too good. If so, you're on the right track. You can do better. Wouldn't it be great if there was a low-risk/high-return investment? Well, there is! It's found in the stock market. We'll be exploring that soon.
In the meantime, though, check out this little chart, which tries to show you how risky some different kinds of investments are and what kinds of returns they might give you.
(high) |---------Lotteries
| |
|----------|------------------------------------------Stocks
RISK | | |
|----------|------------------------Bonds |
| | | |
(low) |----------|--Savings accounts | |
| | | | |
----------------------------------------------------------------------
(low) RETURN (high)
The lesson here? Well, it's that in order to earn bigger returns, you have to take on a little risk. But there's no need to take on a lot of risk. A reasonable amount of risk can offer you a pretty good return.
The Power of Returns
Let's see how important rates of return are. Pretend that you invest $100 -- just $100 -- today. You don't add anything to it. We'll see how much it grows to in 10 years, 25 years, and 40 years. Let's check this out for several different rates of return. We'll try it with an average return of 2%, which is what some banks pay you in interest in your savings account. We'll also try it with 5%, 10%, 15%, 20%, and 25%.
Look at the chart below and see what a difference the rate of return makes. (And what a difference time makes, too!) Keep in mind that we're just using a $100 investment here, as an example. That's $100 invested just once, not every year. You could surely invest a lot more than that over many years. Maybe even more than that in your first investing year!
Rate of in 10 in 25 in 40 Return years years years 2% $122 $164 $221 5% $163 $339 $704 10% $259 $1,083 $4,526 15% $405 $3,292 $26,786 20% $619 $9,540 $146,977 25% $931 $26,470 $752,316Now that you understand what risk and return are, you should have no trouble understanding our sections on ways to grow money and ways to lose it.
Fool on!
All About Investing
Risk and Return
The Rule of 72
Ways to Grow Your Money
Ways to Lose Your Money