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You'll often see these two grouped together in investment discussions, because they're directly related: The more reward you want from an investment, the more risk you must be willing to assume.

Essentially, all investments carry some form of risk — although some investments, like money market funds, significantly reduce your exposure to it. For example, stock funds carry a higher risk of principal loss, while bond funds are accompanied by interest rate risk, which is the risk that interest rate changes will affect the value of your investment.

Even investing very conservatively has its risk: the risk that inflation may rise faster than your investment returns, which means you lose purchasing power just when you need it most. There's also the risk that you've invested too conservatively to meet your goals.

Your tolerance for risk

In any case, it's important to assess your feelings about risk. Just how comfortable are you with the idea that you could lose investment dollars? Would you be comfortable with an investment that may lose money from time to time, if it offers the potential for higher returns than a bank deposit or money market fund? Going one step further, would you be comfortable with an investment even if it lost 10% of its value over the course of a year?

To help you decide, you should also factor in your current financial situation, and ask yourself these questions:

How much outstanding debt (including your home mortgage, auto loan, or credit card payments) do you owe? Make sure you have enough money to pay off those debts before you put money at risk in the stock or bond market. But don't sell yourself short - start preparing for the future today, even if you have only a relatively small amount to invest.

Do you have enough money set aside for unforeseen emergencies? A money market fund might be the place to set aside some money to take care of unforeseen situations.

Below you'll see a broad ranking of the major investment categories and their levels of risk and reward. This is just a general reference tool; even within these categories, there are varying levels of risk and reward.



Low Risk/
Return
Potential

 
Capital Preservation
  • Bank certificates of deposit
  • Short-term government securities
  • Short-term money market securities
  • Short-term tax-exempt municipal bonds
  • Mutual funds that invest in the above short-term investments
Income
  • U.S. government bonds
  • High-quality U.S. corporate bonds
  • Tax-free municipal bonds
  • Mutual funds that invest in U.S. government,corporate, or municipal bonds
Growth and Income
  • Dividend-paying stocks and bonds
  • Mutual funds that invest in dividend-paying stocks and bonds
Capital Growth
  • Growth stocks
  • Emerging growth stocks
  • Mutual funds that invest in growth and emerging growth stocks
   
High Risk/
Return
Potential


Generally speaking, mutual funds that invest primarily in any one of these types of securities will have risk and reward characteristics similar to that security type.

Although investing can be profitable over the long term, you should know that it can involve a considerable amount of risk. Unlike bank deposits, mutual funds are not insured or guaranteed by the U.S. government or any other financial institution. In other words, you could lose some or all of the money that you invest.

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