Almost everything we do involves a measure of risk, whether it’s piloting a jet, changing careers or tackling your first do-it-yourself home remodeling project. But we take those risks because of the potential rewards.
The same is true of investing. Generally, investments with higher risk, such as stocks, offer the greatest growth potential over the long term.* More conservative investments, such as bonds, usually offer lower risk but lower returns over time. The least risky investments, such as money market accounts, provide the lowest growth potential.
Common investment risks
- Market risk (volatility) is the risk that the market for an entire investment class (such as stocks or bonds) or a particular sector of the market (such as technology, energy or health care) will drop due to the overall economic or political environment.
- Business risk affects a specific investment—for example, the chance that a stock or bond you purchase will decline in value or become worthless.
- Credit or default risk is the risk that a bond issuer will not be able to make the interest payments it promised.
- Inflation risk means that your investment return may not keep up with inflation. For example, if annual inflation is 3 percent and your investment earns 1 percent, you could lose 2 percent of purchasing power each year.
- Liquidity risk means you may not be able to sell when you want to because there is little or no demand for your investment.
- Currency risk involves fluctuations in the value of foreign currency against the U.S. dollar. Other risks for foreign investments may include differences in legal or accounting rules and political instability.
Three strategies to manage risk
- 1. Asset allocation—dividing your money among stocks, bonds and cash equivalents. If one asset class is down, another might be up, helping to smooth out volatility. If you have a long investing timeline, you may want to put more of your money into stocks. If you need the money soon, you may want to move a larger percentage of your portfolio into more conservative investments, but keep some stocks for future growth potential.
- 2. Diversification—spreading your money among different investments within each asset class so the performance of one particular investment does not have an outsized impact on your entire portfolio.**
- 3. Systematic investing (also called dollar-cost averaging)—investing regular amounts of money at fixed intervals regardless of what the market is doing.** Dollar-cost averaging can help remove the emotion from investing decisions.
How much risk should you take?
Figuring out how much risk to take with your retirement savings involves analyzing your goals, timeline, any guaranteed retirement income (pensions, Social Security, etc.), your tax situation and how much volatility—or ups and downs in investment value—you can handle and still sleep at night.
A financial advisor can also help you explore your goals in order to build an appropriate investment strategy.
*Source: 2014 Ibbotson® Stocks, Bonds, Bills, and Inflation® (SBBI®) Classic Yearbook, Morningstar, Inc. as measured by large-company stocks from 1926 through 2013. Past performance is not a guarantee of future results.
**Neither diversification nor systematic investment can guarantee a profit or protect against loss in a declining market.
This article is intended to provide general information and should not be considered tax or financial advice. Please consult a tax or financial advisor for specific guidance on tax laws and your individual financial situation.