To most people, "risk" evokes negative images -- driving faster than the speed limit, placing bets on "a long shot," or traveling alone to unfamiliar places. Mention risk in terms of investing, and people might think about losing their life's savings. But in reality, investment risk comes in many forms, and each can affect how you pursue your financial goals. The key to dealing with investment risk is learning how to manage it.
Step one: understand the various risks involved
Investment risk is generally defined as the probability that an actual return on an investment will be lower than the investor's expectations. Fear of losing some money is probably one reason why people may choose conservative investments, even for long-term savings. While investment risk does refer to the general risk of loss, it can be broken down into more specific classifications. Familiarizing yourself with the different kinds of risk is the first step in learning how to manage it within your portfolio.
Also known as systematic risk, market risk is the likelihood that the value of a security will move in tandem with its overall market. For example, if the stock market is experiencing a decline, the stock mutual funds in your portfolio may decline as well. Or if bond prices are rising, the value of your bonds could likely go up.
Most often associated with fixed-income investments, this is the risk that the price of a bond or the price of a bond fund will fall with rising interest rates.
The risk that the value of your portfolio will be eroded by a decline in the purchasing power of your savings, as a result of inflation. Inflation risk needs to be considered when evaluating conservative investments, such as bonds, bond funds, and money market funds* as long-term investments. While your investment may post gains over time, it may actually be losing value if it does not at least keep pace with the rate of inflation.
It comes into play with bonds and bond funds. It refers to a bond issuer's ability to repay its debt as promised when the bond matures. Bonds and bond funds are given credit ratings by such agencies as Moody's and Standard & Poor's. In general, the higher the rating, the lower the credit risk. Junk bonds, which generally have the lowest ratings, are among the riskiest in terms of credit. People who invest in them therefore typically seek higher yields to compensate for their higher credit risk.
In addition, international investments involve such risks as fluctuating currency values (currency risk) as well as the potential for social, political, and economic upheavals that may affect a country's markets.
Step two: manage the risks with diverse investments
The old cliche, "Don't put all your eggs in one basket," is very applicable to the realm of investing. The process of diversification, spreading your money among several different investments and investment classes, is used specifically to help manage market risk in a portfolio. Because they invest in many different securities, mutual funds can be ideal ways to diversify.
Selecting more than one mutual fund for your portfolio can further manage risk. Also consider the potential benefits of selecting investments from more than one asset class: When stocks are particularly hard hit due to changing conditions, bonds may not be affected as dramatically.
Step three: match your investments to your goals
Before you can decide what types of investments are appropriate from a risk perspective, you need to evaluate your savings goals. Is your goal preservation of principal, generating income for current expenses, or building the value of your principal over and above inflation? How you answer this will enable you to find an appropriate balance between the return you hope to achieve and the risk you are willing to assume.
Match time horizon with your investment choices
Examine your time horizon for meeting your goals, and consider how comfortable you may be riding out short-term losses in the value of your investments. Remember, the longer your time horizon, the more volatility you can tolerate in your portfolio. At the same time, long-term investors need to be concerned about inflation. If you are investing your retirement funds, you may also be concerned about building capital over the long term.
For example, investors pursuing long-term goals (such as retirement) will be most concerned with long-term growth and managing inflation risk. Their portfolios will likely be more heavily weighted in stock investments, as these have historically provided the highest long-term returns and outpaced inflation by the widest margin, although past performance does not guarantee future returns. These investors may also devote some money to bonds and money market investments to help manage the higher risks associated with stocks. Keep in mind that stocks offer long-term growth potential but will fluctuate and may provide less current income than other investments.
On the other hand, people already in retirement may need to rely heavily on the income from their portfolios. Therefore, they may seek to manage income and manage risk of short-term losses. Their portfolios will likely be weighted in high-quality, lower-risk bond and money market investments, with some stocks in the mix to maintain growth potential.
Inappropriate investments: the unseen risks
When thinking about how to balance risk and return in your portfolio, don't forget that the risk of loss is not the only kind of risk. Give some thought to the risk of investing too conservatively and not reaping a high enough return potential to provide for your financial future. Also be aware of investing in instruments that may be too risky for your shorter-term goals. A financial professional can help you select investment vehicles that are suitable for your goals.
As you consider each particular investment, research its performance history and risk characteristics. For example, if it's a stock fund, how drastically has it responded to drops in the market? How long has it taken to recoup losses? How has it performed over a time frame similar to your own? For a bond fund, consider also the average maturity of bonds held in the particular fund.
Risk has its potential rewards
In life, almost every attempt at success involves a bit of risk and your investment strategy is no different. By devoting time to examining your goals, conducting some research, and working with a financial professional, you can learn how to manage risk in your portfolio by choosing appropriate investments.
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Article initially appeared on equitable.com
Credit: equitable.com, NYSE
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