Investment Risk vs. Rewards

Every investor has their own unique risk tolerance, referring to the amount of risk that they are willing to take in order to accomplish a specific level of investment return. In fact, there is an ideal investment return for any specific level of risk, otherwise called the Efficient Frontier. Understanding the relationship between risk and reward will help an investor to select the best portfolio and to have the most realistic expectations of its annual level of return.

Investors can often be categorized into one of 4 risk categories, aggressive, moderately aggressive, moderate and conservative. Each of these risk tolerance categories corresponds to investor characteristics such as time frame, expected return and investment objectives.

Aggressive Investor

An aggressive investor is someone who is trying to out pace the S&P 500 Index, or targeting an annual return above 10-11%. An aggressive investor is often someone who is not seeking income, but who is seeking capital appreciation. Also, an aggressive investor is someone who has a time frame greater than 8 years. The investment mix of an aggressive portfolio will be heavily, if not entirely weighted towards equity investments.

Moderately Aggressive Investor
A moderately aggressive investor is someone who is trying to pace the S&P 500 Index, or who is targeting an annual return of 9-10%. A moderately aggressive investor is someone who is not seeking income, but who is seeking capital appreciation. The suggested investment time frame for a moderately aggressive investor is between 7-10 years and the investment mix is largely weighted to equity investments, although there is typically a small portion dedicated to fixed investments.

Moderate Investor
A moderate investor is someone who is targeting an investment return between 7-9% and is either someone seeking moderate investment growth or someone who is seeking current income. A moderate investor is someone who is often preparing for retirement, beginning to shift their focus from capital appreciation to capital preservation. The investment mix is often nearly equally weighted between equity and fixed investments. The suggested time frame for a moderate investor is typically 5-7 years.

Conservative Investors
A conservative investor is someone who is targeting an investment return well below the S&P 500 Index, or the average for the stock markets. A conservative investor is someone who is most commonly seeking a current income stream and who is more commonly concerned with capital preservation rather than capital appreciation. The expected yield of a conservative portfolio is between 5-7% per year, with the vast majority of investments falling in the fixed category rather than the equity category. The suggested time frame for a conservative investor is typically 1-4 years.

Understanding risk tolerance as it compares to the expected portfolio returns in an important concept to fully understand. For each given level of risk, there is a maximum expected portfolio return. This return is important for both reaching investment objectives as well as for generating required current income needs. Once an risk tolerance is chosen, individual investments will be chosen and managed over time to generate the desired or expected portfolio return over the investment time frame.

Understanding CD Types

If you have made the choice to invest into CDs, you will select among the various CD types for your personal investment portfolio. A CD by definition is an investment certificate that grants the bearer of the certificate a specific rate of interest at the certificate’s maturity date. CD rates will have maturity dates that vary from one month to 5 years in length and are most typically issued by a FDIC insured bank.

CD rates will often range based upon the maturity dates. For example, a $10,000 1 year CD may pay a rate of 2.5% at its maturity. And, a 5 year CD rate may be paying 4.25% at its maturity date. The longer maturity CD rates will offer higher rates as they have a higher risk to the investor than a shorter term CD.

Some of the major CD types are Callable CDs, Jumbo CDs, Inflation Linked CDs and Zero coupon CDs.

Callable CDs

Similar to fixed equity products, CDs can have a callable feature. A callable feature is often included on fixed investments to give the Issuer the option of calling the investment in the event that interest rates change enough to place the Issuer in an unfavorable position. The benefit to the investor is that Callable CDs often bear a higher interest rate to compensate for the added risk that the investor is taking with relating to the chance that the CD will be called prior to its maturity date. If interest rates decline, investors should be prepared for the possibility that their CDs will be called, causing them to reconsider their overall investment strategy with the money released from their CDs.

Jumbo CDs

Jumbo CDs are sold in denominations above $100,000 and while individual investors can invest into them, they are most commonly purchased by institutional investors. Institutional investors can include corporate investors or mutual fund managers. The CD rates for Jumbo CDs will range based on their issuers and maturity dates.

Inflation Linked CDs

Inflation is a common concern of investors using cash instruments within their portfolio, as it can erode purchasing power over time. An inflation linked CD is a federally insured type of debt instrument that provides investors a form of inflation protection through the use of variable interest rates. The interest rates will vary based upon a set standard, tied to the national Consumer Price Index (CPI). These offer CD rates that are below traditional CDs as they pose significantly less risk to the investor as they offer this added inflation protection.

Zero Coupon CDs

Investors may have heard of zero coupon bonds, but may not be familiar with zero coupon CDs. A zero coupon CD is one that is purchased well below the coupon rate. With regards to CD rates, the coupon rate refers to the interest rate expected and the term ‘zero coupon’ refers to a CD that will not in fact make interest payment. The interest stated will be paid to the investor when the CD matures, but the investor will be charged what is called phantom income for the interest payments not received on an annual basis. The advantage is that the CD rate is often higher, but the investor needs to be aware of the annual taxes in order to set aside those needed funds.