Understanding risk and return can be your passport to success in investing. Here is how they work, and how they relate to each other.

You invest in order to earn a return on your investment. Return can take a variety of forms, including interest, dividends and capital appreciation (increase in value). Return is usually expressed as a percentage, whether as a rate of interest or a percentage increase in value.

Keep in mind that two factors can have a significant impact on actual return. One is income taxes. A taxable investment earning an 8% annual rate of return is earning the equivalent of 5.76% after taxes for the taxpayer in a 28% tax bracket. This is why tax deferral — a characteristic that is found in the Retirement Plan and TAS — is such an important advantage.

The other important factor is inflation, which also reduces your return. An investment earning an 8% annual rate of return during a period when inflation is running 3% has a 5% real rate of return.

There are five basic kinds of investment risk.

The risk that the issuers of an investment may run into financial difficulties and not be able to live up to their promises. Companies cannot always prepare for unforeseen circumstances, which generally cause stock prices to go down.

An example is a corporation that issues bonds then goes into bankruptcy and defaults on the periodic interest payments and/or the repayment of principal. The buyer of a stock runs the risk that the corporation might reduce or eliminate dividend payments in tfuture.

The risk that the value of your investment will fluctuate as a result of market conditions. You might buy the stock of a promising or successful company, only to have the market value of your stock fall with a generally falling stock market. Part of market risk has to do with your timing on entering the market.

The risk caused by changes in the general level of interest rates in the marketplace. This type of risk is most apparent in the bond markets, because bonds are issued at specific interest rates. Generally, a rise in market interest rates tends to cause a decline in market prices for existing bonds, while a decline in interest rates tends to cause a rise in bond prices.

The risk that the return on your investment fails to outpace inflation. Thus, although you may think a traditional bank savings account is relatively risk-free, you actually are losing purchasing power unless the interest rate on the account exceeds the current rate of inflation in the economy.

All investments carry some degree of risk, either of loss of capital (value) or loss of purchasing power. Typically, though, the return on your investments will compensate you for the risk. The greater the risk you are willing to take, the greater your potential return. Conversely, if you are willing to invest only in very safe, low-risk investments, your return likely will be correspondingly low.

This is the risk/return tradeoff. As a general rule, the lower the investment risk, the lower the return; conversely, the higher the risk, the higher the potential return.

How much investment risk can you tolerate? Before you decide, you will need to understand the five types of investment risk: business risk, credit risk, market risk, interest rate risk and purchasing power risk. The following quiz will help you gauge your understanding of investment risk.

1. Business risk:
(a) Is the chance that unforeseen circumstances, such as a lawsuit against a company or a product failure, may decrease the value of your investments.
(b) Can be company-specific or industry-wide.
(c) All of the above.

All of the above (c) is the right choice. Companies cannot always prepare for unforeseen circumstances, which generally cause stock prices to go down. Diversifying your investments into different industries is one way to lessen business risk.

2. Credit risk means:
(a) A bond insurer may be unable to make interest payments or repay principal when the bonds come due.
(b) A stock issuer may stop paying dividends to stockholders because of financial troubles.
(c) All of the above.

The correct answer is (c). To combat credit risk, consider putting a portion of your portfolio into U.S. Treasury bonds and blue chip stocks.

3. Which of the following statements is true?
(a) When interest rates are raised, bond prices typically fall.
(b) When interest rates go down, bond prices usually increase.
(c) Both (a) and (b).

The answer is (c). Choosing a diversified bond fund containing securities of various maturities or choosing a cash equivalent option can help counter interest rate risk.

4. The possibility that the entire stock market may decline is called market risk. Unfavorable economic news and non-economic events (like war) can affect both stock and bond markets. To combat market risk, investors should:
(a) Diversify investments.
(b) Stop investing entirely.
(c) Sell all stock holdings.

If you answered (a), you are correct. Diversifying among stocks, bonds and cash can be a safe course to follow to reduce investment risk when markets are down.

5. The price of consumer goods:
(a) Does not change from year to year.
(b) Decreases every year.
(c) Usually increases from year to year.

The correct answer is (c). The price of goods usually increases from year to year because of inflation. This increase leads to purchasing power risk (the chance that today's dollar may buy less in the future). To overcome purchasing power risk, look for investments that closely match your risk tolerance and investment time horizon, and that yield returns that typically have outpaced inflation in the past.

Now that you have a better understanding of investment risk, you can determine your personal risk tolerance. Your own risk tolerance will help you determine how best to invest your savings.

Your answers to the following questions may give you a better idea of the risks you are comfortable with. Circle the answer that best describes how you would react to each situation.

1. You are ready to open a savings account. You are most comfortable...
(a) putting your money in a money market fund that carries no guarantees, but that typically pays favorable interest rates
(b) buying a certificate of deposit that guarantees the interest rate for five years, even though the interest rate is modest

2. You have set aside some money that you want to invest. You decide to...
(a) keep your eyes open for an exciting high-tech company, and sell the stock as soon as it goes up 20%
(b) buy stock in a large, established company, and hold the investment for the long term

3. You inherit $10,000 from a distant relative. Your first instinct is to...
(a) invest the money in a stock index fund, because the stock market is doing well
(b) put the money in a bank savings account

4. You are refinancing your home. You would prefer...
(a) a variable rate loan with a 6.5% starting interest rate that could increase to 12% depending on the economy
(b) an 8.5% fixed-rate loan that would not change for the life of the loan

5. You are looking for a credit card with a lower interest rate than the card you have now. You choose. . .
(a) a card with a six-month introductory rate of 6% that is guaranteed never to go above 13%
(b) a card with a six-month introductory rate of 7%, that changes to the prime rate plus 1% after six months (the prime rate currently is 8.25% and has ranged from 6% to 11.5% over the last 10 years)

If you responded with the letter (a) in the majority of the situations above, you probably tend to be more aggressive with your financial decisions. If you selected (b) most often, you tend to be more conservative and may not want to put your money at risk in order to make potentially greater returns. A mixture of the two means you fall somewhere in the middle and are likely to be most comfortable diversifying your investments, or spreading them out across a number of different funds.

MMBB's investment choices range from conservative funds with relatively predictable returns to more aggressive and potentially more rewarding funds. Whatever your risk tolerance, diversifying your retirement accounts in a variety of types of investment funds can help you increase your returns and decrease your risk.