4.02 Investment Types and Risk Management

Risk vs. Return

  • Risk and return are directly related: higher risk, higher potential return; lower risk, lower potential return.

  • Entrepreneurship is risky due to the high failure rate of small businesses.

  • Rewards for entrepreneurs include solving problems, financial gains, and satisfaction.

Risk Profiles

  • Risk averse: Avoid taking much risk.

  • Risk tolerant: Willing to take more risk.

  • Risk profiles depend on age, personality, ability to earn income, life goals, liquidity needs, and time horizon.

Factors Affecting Risk Tolerance

  • Age: Retired individuals prefer low-risk investments.

  • Goals: Specific financial goals may lead to riskier investments.

  • Liquidity needs: Short-term needs require secure, liquid investments.

  • Time horizon: Longer time horizons allow for riskier investments like stocks.

  • Personality: Personal preferences for or against risk.

Types of Investments

  • Ownership Investment: Investor owns an asset (stocks, real estate, business).

  • Lending Investment: Investor is the lender, receiving interest (bonds, CDs, savings accounts).

  • Securities: Financial investments in equity (stock) or debt (bonds) that can be traded.

  • Derivatives: Bets on the price of an underlying commodity (options, futures, swaps).

  • Governed by the U.S. Securities and Exchange Commission (SEC).

Ownership Investments

  • Stocks: Represent ownership in a company.

  • Real Estate: Land or structures bought, leased, or sold for profit; less liquid than stocks.

  • Ownership investments are generally riskier but offer higher potential returns.

Lending Investments

  • Savings Accounts: Lending money to the bank; FDIC-insured up to 250,000250,000; low risk, low returns.

  • Bonds: Governments and corporations borrow money and pay interest; low risk, low returns.

  • Money Market Funds: Short-term, liquid investments with low risk and low returns.

  • Certificates of Deposit (CDs): Fixed interest rate over a fixed term; less liquid, penalty for early withdrawal.

Other Types of Assets

  • Cash: Loses value due to inflation; should not be held in large amounts.

  • Alternative Investments: Commodities (corn, cows), precious metals (gold, silver), and collectibles (antiques, coins).