I am trying to hedge my portfolio and I want to see my options here. I am trying to list out some investments from the safest to the riskiest. I will list a few that I am aware about. Would be very helpful if somebody can add to that list in order.

1.) Government bonds(Considered the safest?)

2.) Savings account

3.) Credit Deposits

4.) Money market Funds

5.) Hedge Funds.

6.) Stock Market

7.) Derivatives (Riskiest?)

  • If you want to use volatility as a proxy for risk (which makes the math easier - er, sorry, possible), then this is easy. If you don't, then you need to decide what you mean by 'safe' and 'risky', then take it from there... – AakashM Oct 29 '14 at 9:18

With every caveat that Rick said plus many many more lets have some fun. One common way to measure risk is volatility of returns roughly how much the value of your asset jumps around. Interestingly, the following ordering is fairly similar for many other common measures of risk.

The first three on the list would be mostly interchangeable. Generally, putting your money in "cash" investments has no real day-to-day price variability and the main risk is that the bank won't give you your money back at the end. Money market funds are last as they can "Break the buck".

  1. Savings Accounts
  2. CDs
  3. Money Market Funds

To get a feel for the next few on the list I'm using previous 360 day volatility numbers for representative broad indices (asof 2014-10-27). While these volatility values can move around quite a bit, the order is actually remarkably stable.

  1. Hedge Funds 3.2% (HFRX)
  2. Government Bonds 5.5% (Bloomberg US Govt 7-10 Year, foreign govt would be higher)
  3. Stocks 11.4% (S&P 500)

Hedge funds might seem out of place here, but remember that hedge funds can hold be long and short at the same time and this can cancel out daily variation. However, Hedge funds do have plenty of risks that may not be well accounted for by this measure.

For derivatives I'll refer to back to Rick's answer.

This is a measure for broad investment in these categories your particular investment in Long-term Capital Management or Argentine Bonds may vary.

It is important to note that your return on your investment generally grows as you go toward more risky investments down this list as people generally expect to be rewarded in the long term for risky investments.

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I think your premise is slightly flawed. Every investment can add or reduce risk, depending on how it's used. If your ordering above is intended to represent the probability you will lose your principal, then it's roughly right, with caveats.

If you buy a long-term government bond and interest rates increase while you're holding it, its value will decrease on the secondary markets. If you need/want to sell it before maturity, you may not recover your principal, and if you hold it, you will probably be subject to erosion of value due to inflation (inflation and interest rates are correlated).

Over the short-term, the stock market can be very volatile, and you can suffer large paper losses. But over the long-term (decades), the stock market has beaten inflation. But this is true in aggregate, so, if you want to decrease equity risk, you need to invest in a very diversified portfolio (index mutual funds) and hold the portfolio for a long time. With a strategy like this, the stock market is not that risky over time.

Derivatives, if used for their original purpose, can actually reduce volatility (and therefore risk) by reducing both the upside and downside of your other investments. For example, if you sell covered calls on your equity investments, you get an income stream as long as the underlying equities have a value that stays below the strike price. The cost to you is that you are forced to sell the equity at the strike price if its value increases above that. The person on the other side of that transaction loses the price of the call if the equity price doesn't go up, but gets a benefit if it does. In the commodity markets, Southwest Airlines used derivatives (options to buy at a fixed price in the future) on fuel to hedge against increases in fuel prices for years. This way, they added predictability to their cost structure and were able to beat the competition when fuel prices rose. Even had fuel prices dropped to zero, their exposure was limited to the pre-negotiated price of the fuel, which they'd already planned for.

On the other hand, if you start doing things like selling uncovered calls, you expose yourself to potentially infinite losses, since there are no caps on how high the price of a stock can go.

So it's not possible to say that derivatives as a class of investment are risky per se, because they can be used to reduce risk.

I would take hedge funds, as a class, out of your list. You can't generally invest in those unless you have quite a lot of money, and they use strategies that vary widely, many of which are quite risky.

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