Before choosing savings vehicles or investments, it’s important to understand the relationship between risk and reward. In general, higher-risk investments have higher potential rewards — and higher potential losses.

Risk is inherent to investing. If you’re an extremely cautious investor, you run the risk that inflation will outpace your earnings and erode your purchasing power. On the other hand, higher-risk investments tend to be more volatile (i.e., have more ups and downs), which can be disastrous for short-term investors. You need to determine how much risk you can tolerate—without losing sleep—before you invest.

A variety of factors, including your age, personality, and investment time frame (i.e., how long until you may need the money) may influence your tolerance for risk. See if you recognize yourself in one of the following three investment styles.

• The conservative investor can’t stand the idea of losing the principal (i.e., the initial amount of money invested). This investor prefers to put money in fixed-return investments where the principal and interest are guaranteed. Savings accounts and certificates of deposit (CDs) that are generally insured by the Federal Deposit Insurance Corporation (FDIC) for up to $100,000 are examples. Be aware, however, that the rate of return may not outpace inflation, so there is still a risk — the risk of losing earning power.
• The moderate investor certainly doesn’t want to lose any principal, but realizes that greater reward goes hand-in-hand with greater risk. This investor is most comfortable with a combination of low- and high-risk investments. Market drops may make this investor flinch but not worry excessively, because he or she is aware that the potential for greater long-term gain means riding out the dips.
• The aggressive investor has a constitution that can handle market swings. This investor seeks the greatest reward possible for every dollar invested, and has no problem with the idea of investing in speculative stocks, futures, or junk bonds. While this winner-take-all attitude holds the potential for great gain, it also holds the potential for great loss. And since loss is something an investor needs time to recover from, this type of aggressive investing is better suited for long-term financial goals.

Striking a balance between risk and return is important to every investor, and one way to accomplish a balance is through diversification. When you diversify, you distribute your money across several types of investments, some with higher risk and some with lower risk. A diversified portfolio might include stocks, bonds, and savings vehicles (e.g., CDs) to help even out the ups and downs of the market. You’ll want to pick your own mix based on your risk tolerance, investment goals, and time horizon. Diversification cannot eliminate the risk of investment loss.