Dealing With the Risks of Investing
Familiarizing yourself with the different kinds of risk is the first step in learning how to manage it with
Worried about the risks of investing? Understand different types of risk and strategies to manage market risk, interest rate and credit risks, and the risk of not meeting your goals. 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. This three-step process will show you how.
Step One: Understand Risk
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.
Risk comes in many forms, including:
Market risk: 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 may also go up.
Interest rate risk: 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.
Inflation risk: This is 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.
Credit risk: This type of risk 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.
International investments also involve additional risks, including the possibility of fluctuating currency values (currency risk) and the risk that political and economic upheavals may affect a country’s markets.
Step Two: Diversify1
The process of diversification, spreading your money among several different investments and investment classes, is used specifically to help minimize market risk in a portfolio. Because they invest in many different securities, mutual funds may be ideal ways to diversify. Selecting more than one mutual fund for your portfolio can help further reduce 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. In part, that may be because bond total returns may be tied more to income (which can cushion a portfolio) than price changes.
Step Three: Match Investments to 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.
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 may be able to tolerate in your portfolio.
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.
Written by: Carl Trevisan and Stephen Bearce
1Diversification does not ensure a profit or protect against a loss.
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This column is provided through the Financial Planning Association, the membership organization for the financial planning community, and is brought to you by Carl M. Trevisan, a local member of FPA and Stephen M. Bearce.
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