Understanding Risk & Return

As you navigate the complexities of investments, portfolio diversification is one of the most emphasized strategies you'll encounter. But why is it so essential?

Understanding Portfolio Diversification

Diversification is spreading your investments across various types of assets, be it stocks, bonds, real estate, or other categories. This approach ensures you're not putting all your eggs in one basket. In finance, a more diverse basket often means a more stable one.

Balancing Risk and Return

Every investment comes with its degree of risk. Generally:

  • Low-risk investments offer steadier but often smaller returns. They're akin to calm waters—less turbulent, but the journey might be slower.
  • Medium-risk investments strike a balance between potential profit and potential loss. They offer a compromise between safety and growth.
  • High-risk investments have the potential for high returns but have greater volatility. The promise of significant gains can be alluring, but the potential for losses is also higher.

The Power of Diversification

By diversifying, you reduce the impact of a poor-performing investment on your overall portfolio. While one asset might be down, another might be up. The goal is that some investments' positive performance will offset others' negative performance. This results in a smoother and potentially more predictable growth trajectory.

Using This Calculator

To visualize the impact of diversification, select various rates of return for low, medium, and high-risk investments. Witness how different combinations can provide a range of potential outcomes for your portfolio. The aim is not to mindlessly chase the highest returns but to achieve a balance that you're comfortable with in terms of potential growth and associated risks.

Remember, a well-diversified portfolio aligns with your financial goals, risk tolerance, and investment horizon.

Turning on "Power Mode" will display the results of the calculations alongside the input fields. When "Power Mode" is off, descriptive information sits alongside the input fields for a more informative learning experience.
Investment Info
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Principal investment is the amount of money you plan to initially put into your investment.
Years invested is the number of years you plan to hold your investment.
Low Risk Strategy
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Rate of return is the annual percentage gain or loss on a low risk investment, such as a savings account, certificate of deposit, or treasury bill. Typically, a low risk investment will return 1% to 5% each year, with little to no downside.
Medium Risk Strategy
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Best case rate of return is the best case annual percentage gain or loss on a medium risk investment, such as a mutual fund or index fund. In a best case scenario, it is possible for a medium risk investment to increase 10% to 20% year over year.
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Expected case rate of return is the expected annual percentage gain or loss on a medium risk investment, such as a mutual fund or index fund. Based on previous performance, one can reasonably expect a medium risk investment to increase 7% year over year.
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Worst case rate of return is the worst case annual percentage gain or loss on a medium risk investment, such as a mutual fund or index fund. In a worst case year, a medium risk investment could decrease up to -20% in value.
High Risk Strategy
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Best case rate of return is the best case annual percentage gain or loss on a high risk investment, such as an individual stock, high-yield junk bond, or cryptocurrency. In a best case scenario, it is possible for a high risk investment to increase 20% to 100% year over year.
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Expected case rate of return is the expected annual percentage gain or loss on a high risk investment, such as an individual stock, high-yield junk bond, or cryptocurrency. High risk assets can reasonably increase or decrease by 15% in value year over year.
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Worst case rate of return is the worst case annual percentage gain or loss on a high risk investment, such as an individual stock, high-yield junk bond, or cryptocurrency. In a worst case year, a high risk investment could decrease up to -20% to -99% in value.

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Investment Cases by Risk Category

Returns On Investments
Best Case Expected Case Worst Case
Low Risk Strategy
Medium Risk Strategy
High Risk Strategy

As you evaluate your investment journey through this calculator, you must recognize that investment strategies aren't static. They evolve in tandem with your financial goals and the time you have to achieve them. Here's a quick overview:

Time Horizon and Risk

  • Longer Time Horizons: When you're further from your financial goal, you typically have more time to recover from potential setbacks. This longer timeframe allows for a greater acceptance of risk. Historically, while markets have experienced fluctuations, they tend to grow over extended periods. Hence, with a longer time horizon, you might be more inclined to adopt a higher-risk, higher-return strategy.
  • Shorter Time Horizons: As you near your financial goal, the focus often shifts towards preservation. There's less time to recover from significant losses, which can prompt a more conservative approach. It's common for investors to gradually transition from high-risk to low-risk assets as they approach their goal.

Rebalancing Over Time

Your asset allocation—the distribution of your investments among different risk categories—may drift over time due to market movements. Periodic rebalancing ensures that your portfolio aligns with your intended strategy and risk tolerance. Buying or selling assets to maintain your desired allocation is a practice.

Fluid Strategies for Fluid Goals

Life is unpredictable, and your goals might change. Marriage, children, buying a house, or sudden medical expenses can shift your financial targets. An adaptable investment strategy is pivotal. Review and adjust it as necessary, keeping your current situation and future aspirations in mind.

Summary

While risk and return are fundamental components of any investment decision, the temporal aspect—how long you're investing for—plays a crucial role. As you get closer to your goal, re-evaluate and modify your strategy if necessary. Embrace the journey, learn from it, and always prioritize an approach in harmony with your comfort and objectives.