When it comes to investing, few concepts are as powerful or as important to understand as risk. When used appropriately, risk offers investors the opportunity to realize gains. But it also opens you to losing some or all of the money that you invest. That’s why a solid investment plan manages risk through diversification.
Asset Classes Ranked by Risk
Before we get into the rankings, it’s important to acknowledge the fact that all investments carry some level of risk — even those deemed least risky. That’s because there are many different types of investment risk.
The list below ranks asset classes based on the risk that you experience volatility, but does not take into account other risk factors, such as inflation risk, which are also important to consider when constructing your portfolio.
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1. Cash & Cash Alternatives
Cash and cash alternatives — such as money held in a savings account, money market account, certificate of deposit, or money market funds — carry the lowest risk out of all asset classes, as it is extremely unlikely that you will lose principal held in these vehicles.1
However, money kept in cash typically offers little potential to grow your money faster than the rate of inflation, which could lead to inflation eating away at your purchasing power over time. Still, cash and cash alternatives play an important role in stabilizing a portfolio, and can also serve as a reserve to tap when investment opportunities arise, often unexpectedly.
2. Fixed Income/Bonds2
Fixed income investments such as treasury securities, treasury inflation protected securities (TIPS), municipal bonds, and high-quality corporate bonds come next on the list. While they are generally less risky than the assets discussed later, they do carry more principle risk than cash and cash alternatives. This is due in part to the fact that some of these securities trade on the open market, where their prices may fluctuate as market conditions change. For example, as interest rates rise, bonds with longer maturities may have greater declines in value vs. bonds with shorter maturities. Additionally, there is always the possibility, however slim, that a bond issuer may default on its debt.
In exchange for accepting this heightened risk, investors will typically enjoy greater interest payments compared to what they would receive from cash alternatives. Still, these payments may or may not match the rate of inflation.
It is worth noting that not all fixed income investments are the same. Treasury securities and TIPS are typically seen as the safest investment vehicles in this asset class, as they are backed by the U.S. government. Municipal bonds carry slightly more risk, as they are backed instead by state and local governments. Corporate bonds are typically seen to carry the greatest level of risk, as these are tied to the fate of individual companies. Within the corporate bond universe, individual issues may have very different risk profiles, some non-investment grade bonds carrying risks more similar to stocks than higher quality bonds.
3. Commodities
Investing in commodities3 typically involves trading futures contracts for raw materials and products such as agricultural products, precious metals, industrial materials, and fuel. While commodities can experience price fluctuations (particularly because of the way some commodities markets work), they are often seen as a hedge against inflation as the price of goods tends to rise with inflation. Held in isolation, commodities can be a very volatile asset class, however, when held in a diversified portfolio of stocks and bonds, commodities can provide a return pattern that isn’t highly correlated to traditional stocks and bonds.
4. Stocks
Stocks are generally considered to be riskier than bonds, cash alternatives and commodities. While both bonds and cash alternatives offer the investor a promised rate of return, stocks offer no such guarantee.
The share prices of individual company stocks are constantly adjusting based on a variety of factors including the company’s earnings and growth rates, economic reports, and investor sentiment. These factors can cause significant volatility in share prices, especially in the short term.
Of course, different types of stocks carry differing levels of risk. U.S. large-cap stocks are typically viewed as the least risky, as they are typically issued by stable and established companies. Next comes international developed stocks, which provide exposure to established companies outside the United States. U.S. mid-cap and small-cap companies follow, as these are less established (and therefore less stable and predictable) than large-caps. The riskiest stocks tend to be international emerging stocks, due to the uncertainties of investing in an emerging market such as geopolitical risk, currency risk and less developed and/or regulated financial markets.
5. REITs
Real estate investment trusts (REITs) are especially popular with investors who are looking to generate a source of income. That’s due to the fact that REITs, by definition, must distribute at least 90 percent of their taxable earnings each year to shareholders. This typically translates into a dividend yield that is significantly above the average for other assets like stocks.
However, this high yield comes with risks of its own, as REIT prices can move dramatically lower in a relatively short period of time.
Additionally, because dividend payments from REITs are taxed as regular income, investors are typically taxed at their regular income tax rate instead of the more favorable rate applied to long-term dividends and capital gains. This makes REITs less tax-friendly compared to other income-generating investments.
A Required Piece of an Investment Portfolio
Building an investment portfolio is all about managing risk. The goal is to strike the right balance that allows you to be positioned for growth while also minimizing the potential of large losses. Instead of avoiding risk, most investors would be well served by diversifying across asset classes based on their unique financial situation and personal risk tolerance.
A financial advisor or wealth manager can help you determine the proper asset allocation to help you reach your financial goals.
All investments carry some level of risk including the potential loss of all money invested. No investment strategy can guarantee a profit or protect against loss.
1 An investment in any money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any government agency. Although a money market fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in a money market fund. Yield fluctuates. The Fund's sponsor has no legal obligation to provide financial support to the Fund, and you should not expect that the sponsor will provide financial support to the Fund at any time.2 You should carefully consider risks with fixed income securities such as bonds, these include: Interest rate, Duration, Credit, Default, Liquidity and Inflation. Interest rates and bond prices tend to move in opposite directions, for example when interest rates fall, bond prices typically rise. This also holds true for bond mutual funds. A low interest rate environment may cause losses to bond prices and bond funds you own or in the market. Interest rates in the United States are at, or near historic lows, which may increase a Fund’s exposure to risks associated with rising rates. High yield (Junk) bonds and bond funds that invest in high yield bonds present greater credit risk than investment grade bonds.
3 The risk of trading commodities can be substantial as prices fluctuate more than traditional securities. You must consider whether this is a suitable investment. Past performance is not indicative of future results.
