Investment 101: How Risk Can Translate Into a Good or Bad Investment

American dollars.

Between active and passive, which income source are you pursuing? (Image: via Pixabay)

Growing your money through a suitable investment can be tricky. It is sometimes difficult to recognize a good investment among the numerous scams and offers for immediate returns. 

In theory, any investment can sound like a good investment if it is pitched cleverly. This, however, is not a guarantee that you’ll realize a return or even get back your entire principal.

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It’s also important to note that a good or bad investment has nothing to do with the asset’s potential. For example, an asset could have the potential for a significant return, but if it fails, it is still considered a bad investment.

A few tips can be followed to better judge whether an investment is good or bad. So, let’s review some basic considerations before investing.

Risky investments should be avoided.
Don’t just gamble your money away on risky investments. Instead, learn to become a wise investor. (Image: StockSnap via Pixabay)

Understanding risk

Understanding risk is fundamental for any investment; no discussion of returns or performance is meaningful without at least some mention of the risks involved. The trouble for new investors is figuring out where the danger lies, the differences between low risk and high risk, and how this equates to a good or bad investment.

Risk refers to an investment decision’s uncertainty and potential for financial loss. In other words, when you invest your money, you don’t know if you’ll receive the desired returns or experience unexpected losses.

But the risk to your investments doesn’t come just from stock market moves if this is where you choose to invest. The economy, length of investment time, interest rates, etc., all pose potential risks to your investments.

Types of investment risk

The riskWhat it isEffect on investments
Inflation riskThe tendency for prices to increase over timeFuture dollars (your investments) will not have as much buying power
Longevity riskThe risk of outliving your savingsThe length of retirement is undetermined, making it tough to know how much money you’ll need
Market riskThe risk of loss due to financial market performanceStocks vary from day-to-day and year-to-year, which can harm investments
Interest rate riskThe risk to savings and loan rates if interest rates changeInterest rate increases are generally positive for the money you want to grow (investments)
Credit risk (corporate bonds)The risk of default by the issuer of the bondBondholders may not be paid the promised interest or the entire principal

Evaluate your comfort zone in taking on risk

When considering whether an investment is good or bad, one of the biggest mistakes you can make is not understanding the level of risk you are willing to incur. Risk-tolerant investors are willing to take on higher risks in return for maximum returns, while risk-averse investors avoid risk, even if that means missing out on higher returns.

Examples of low-risk investments include bonds, savings, money market accounts, and certificates of deposit (CDs). High-risk investments include stocks, options, currency trading, cryptocurrency, and certain business and real estate investments. Investment portfolios often include a mix of high- and low-risk investments.

This is why diversification and asset allocation are so important when an investor is considering both low- and high-risk investments. The goal is to spread your investments across different asset classes, industries, sectors, and geographic locations. This can help soften the blow of investment losses.

Five house-shaped boxes lined up in a row with a red one in the middle.
Although nothing is certain, a few indicators could help you spot suitable investments. (Image: Flynt via Dreamstime)

Spotting good investments

Although nothing is certain, a few indicators could help you spot suitable investments.

  • Realistic returns: If it sounds too good to be true, it probably is
  • Something you understand: If you are knowledgeable about a particular asset, you can tell whether it has potential or not
  • Reputation: If the asset or company owning the asset is honest about its earnings, has shown growth, and has a solid business model behind the investment, this could signal a good investment

Final word

When considering whether an investment is good or bad, investors must consider their own goals and risk tolerance to determine the right investment balance and the best investment opportunities. Choosing between good and bad investments involves more than just buying safe assets. Any investor must do the proper research and due diligence, whether on their own or with the help of an advisor, to find suitable investments regardless of the asset class.

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