As we have discussed, investing always involves some degree of risk—and risk can come in many flavors, including market risk, liquidity risk, interest rate risk, inflation risk and more. One basic rule of investing is that there’s a direct connection between risk and return, sometimes described as the “risk/reward tradeoff.” In general, the higher the risk that you could lose money, the higher your potential returns.
Making investments of varying levels—and types—of risk can help you position your portfolio for both stability and growth. Equally important, combining investments that pose different risks might help you weather economic storms, and can help you protect your principal and take advantage of opportunities for growth.
When deciding how to invest your 401(k) assets, be sure to consider the various risks each investment choice carries as well as how much risk you are taking elsewhere in your portfolio (outside your 401(k)) and what form that risk takes. For example, if you work for a publicly traded company, your job could be on the line if the company performs poorly—and any deferred compensation in the form of company stock could be at risk. Remember, your risk analysis will always be unique to you. If you have limited assets or assets that you cannot or are not willing to lose, then you will want to think twice about the risks you take—especially risks that could result in your losing your principal or seeing the value of your investment eroded by inflation.
So it’s important to understand the difference between the investments in your 401(k), from the least risky to the most. Then you can create a portfolio designed to help you meet your goals with the level of risk you’re prepared to tolerate.
Investments generally fall into three different asset classes, which carry different levels of risk and have historically provided different average returns:
| Asset Class |
Types of Investments |
Chief Risks |
Average Investment Returns1 |
| Equity |
Stock, stock funds, real estate funds (REITS) |
Volatility, falling prices |
9.9% (large cap) |
| Fixed-income |
Bonds, bond funds, stable value funds, GICs |
Interest rate changes, default |
5.9% (long-term corporate) |
| Cash and cash equivalents |
Money Market funds |
Inflation (except TIPS and I Bonds), interest rate changes |
3.6% (US Treasury bills) |
1 1925-2010. Source: Stocks, Bonds, Bills & Inflation 2010 Yearbook, Morningstar, Inc. Data is based on the S&P 500 Composite Index for stocks, Citigroup Long-Term High-Grade Corporate Total Return Index for bonds, and a U.S. Treasury one-bill portfolio for cash. Past performance does not guarantee future results.
As the chart above indicates, historically stocks as an asset class, in general, have provided higher returns than other asset classes. But stocks tend to have higher risks for as long as you hold them. Individual stocks or stock funds can perform poorly relative to the overall stock market in any given period—and the stock market as a whole can experience sometimes dramatic short-term losses. Keep in mind that in 24 of the 85 years since year-end 1925, stocks have lost money.
In contrast, conservative investments that reduce your risk by guaranteeing your principal and sometimes the return you will earn generally offer more modest rewards. The greatest risk is that these investments might not provide the long-term growth you need to build your account value, especially during periods of high inflation where your rate of return may be less than the rate of inflation. Some—such as TIPS and I Bonds—can eliminate inflation risk, although TIPS and I Bonds are not risk-free investments. Others—such as guaranteed investment contracts (GICs), stable value funds or fixed annuities—might also charge higher fees or impose penalties if you want to move money out because you re-evaluate the rewards they provide.
The graph below indicates the average annual returns for stocks, bonds and cash equivalents over an eighty-five year period.
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