Risk and return
Students should understand that every saving and investment product has different risks and returns. Differences include how readily investors can get their money when they need it, how fast their money will grow, and how safe their money will be.
Savings accounts, insured money market accounts, and CDs are viewed as very safe because they are federally insured. You can easily get to money in savings if you need it for any reason. But there's a tradeoff for security and ready availability. The interest rate on savings generally is lower compared with investments.
While safe, savings are not risk-free: the risk is that the low interest rate you receive will not keep pace with inflation. For example, with inflation, a candy bar that costs a dollar today could cost two dollars ten years from now. If your money doesn't grow as fast as inflation does, it's like losing money, because while a dollar buys a candy bar today, in ten years it might only buy half of one.
Stocks, bonds, and mutual funds are the most common investment products. All have higher risks and potentially higher returns than savings products. Over many decades, the investment that has provided the highest average rate of return has been stocks. But there are no guarantees of profits when you buy stock, which makes stock one of the most risky investments. If a company doesn't do well or falls out of favor with investors, its stock can fall in price, and investors could lose money.
You can make money in two ways from owning stock. First, the price of the stock may rise if the company does well; the increase is called a capital gain or appreciation. Second, companies sometimes pay out a part of profits to stockholders, with a payment that's called a dividend.
Bonds generally provide higher returns with higher risk than savings, and lower returns than stocks. But the bond issuer’s promise to repay principal generally makes bonds less risky than stocks. Unlike stockholders, bondholders know how much money they expect to receive, unless the bond issuer declares bankruptcy or goes out of business. In that event, bondholders may lose money. But if there is any money left, corporate bondholders will get it before stockholders.
The risk of investing in mutual funds is determined by the underlying risks of the stocks, bonds, and other investments held by the fund. No mutual fund can guarantee its returns, and no mutual fund is risk-free.
Always remember: the greater the potential return, the greater the risk. One protection against risk is time, and that's what young people have. On any day the stock market can go up or down. Sometimes it goes down for months or years. But over the years, investors who've adopted a "buy and hold" approach to investing tend to come out ahead of those who try to time the market.
Suggested student activities
- Now that students understand the concept of risk, how would they invest their money and why.
- If students already have selected a stock that they are following, have them chart how the stock has performed for the past two years, five years and 20 years. If an investor started with 100 shares, how much more -- or less -- money would he or she have now?