A critical concept that investors must understand is the relationship between risk and reward. An investment that carries a greater degree of risk, has the potential to generate a greater reward or return to the investor - or at least it should. Risk and reward have a fundamental relationship which can’t be minimized or overlooked.

If there were no direct relationship between risk and reward, then we could have free lunches. Investing would be a walk in the park - no losses and no risk of failure.

In an era when some businesses are judged as too big to fail and the government seems more than willing to protect individuals and groups from their bad decisions, the risk reward concept is being challenged. We have seen recently that “solid investments” in houses, mortgage-backed securities, or credit-default swaps can plunge in value almost overnight when markets dry up. No buyers can be found and the true value of the investment is uncertain. Investors, politicians, and the titans of capitalism have learned hard lessons about risk and reward.

Don’t confuse risk with loss. Risk does not mean there will be a loss on the investment. Risk tells us there is a potential for a loss or a return that is less than anticipated on the investment. Risk does not specify the potential loss, great or small, only that there is a potential for loss.

As an investor, are you willing to assume the level of risk with the investment to gain the potential reward? If you can’t accept any level of risk with an investment, you are not an investor. You are probably someone who will only be comfortable with federally insured deposits or U.S. Treasury Bills, Notes, or Bonds. The only way to know how you will respond to risk is to evaluate your risk tolerance. This is a personal assessment, not a broad measurement of how all investors handle risk. To gain insight into your risk tolerance, take a Risk Tolerance Evaluation - use the Risk Tolerance Worksheet in the book, Investing for Retirement - Surviving a Financial Tsunami. Also, see Risk Tolerance.

All investments carry some level of risk. Here is a list of some of the more common investment risks.

• Inflationary risk - the risk that the purchasing power of income or assets will decrease over time as inflation devalues money.
• Interest rate risk - risk that as interest rates rise, the value of fixed income investments, especially bonds, will decline.
• Liquidity risk - risk that an investment can’t be readily sold; a liquid market for the asset does not exist or has dried up.
• Market timing risk - attempting to predict the future price of a security and timing the purchase or sale to match the prediction. “Timing the market” has never been consistently successful. See Chapter 2 in Investing for Retirement - Surviving a Financial Tsunami.

Other risks an investor may face -

• Call risk - the possibility that a fixed income investment, primarily bonds, will be redeemed before the maturity date. As interest rates decline, high yielding bonds may be called in early - redeemed. To avoid this potential risk, purchase “non-callable” investments.
• Capital risk - risk of losing some or all of the amount invested - the investor's capital.
• Credit risk - a bond issuer may default on interest payments or principal at maturity.
• Currency risk - investments in a foreign country may be negatively impacted by changes in the exchange rate between currencies of other countries.

Review Chapter 6 in Investing for Retirement - Surviving a Financial Tsunami.