Bottom Line Up Front
- Financial investments involve some degree of risk—generally, the higher the risk, the greater the return.
- Understanding common investment terms like liquidity, volatility and inflation can help you build a healthy portfolio.
- Well-balanced asset allocation, diversification and systematic investing (dollar-cost averaging) are three ways investors can successfully manage risk.
Many of the ordinary things we do, like changing jobs or careers or tackling that first do-it-yourself home remodeling project involve some risk. But, we do them because of their potential rewards. The same is true of investing.
It all comes down to your comfort level, what’s commonly called your “risk tolerance.” Generally, investments with higher risk, such as stocks, offer the greatest opportunity for growth over the long term. More conservative investments, such as bonds, usually offer lower risk, but they also earn lower returns over time. The least risky investments, such as money market accounts, provide the lowest growth potential.
Common Investment Terms
- Liquidity. This term refers to how easily you can convert your assets or investments to cash and whether they can be sold at stable prices. An illiquid investment (e.g., partnership shares, hedge funds) means you may not be able to sell quickly because there’s little or no demand for your investment, and it’s harder to determine its fair market value.
- Business stability. When you buy stock or bonds in a particular company, if it loses money or goes bankrupt, the value of your investment could go down or even become worthless.
- Market volatility. This term refers to when the stock market is unstable. In a volatile market, there’s a greater chance that your investments could lose value because it’s acting unpredictably. It usually happens because of a difficult economy or unexpected changes and can affect an entire investment class (e.g., stocks or bonds) or just a particular sector of the market (e.g., technology, energy, health care).
- Credit or default. If you’re interested in buying bonds, you should check the bond issuer’s rating, so you’ll know how likely they’ll be able to make the promised dividend payments. In a default situation, you could lose some or all of the dividends and possibly even some of the principal you invested.
- Inflation. When people talk about inflation, they mean how prices rise and how it affects buying power—for goods and services and for investments. Why does that matter? Because, as prices rise, your investments may not keep up. Here’s an example. Suppose annual inflation is 3 percent, but your investment only earns 1 percent. That 2 percent difference will affect how much you can buy and how much money you’ll make on your investments.
- Foreign investment. Buying foreign stocks may help you diversify your portfolio, but it does involve risk. Many of these markets don’t have the same level of oversight as U.S. markets and are more likely to be affected by events like a sudden political change—which can have a devastating effect on their economy. You’ll also need to account for fluctuations between the value of the foreign money and the U.S. dollar. Other risks for foreign investments may include differences in legal or accounting rules.
Strategies to Manage Risk
- Asset allocation. A simple explanation of this term is dividing your investments among stocks, bonds and cash equivalents. If one asset class isn’t doing well, another might be doing better—which helps you weather the market’s ups or downs. If, for example, you have many years of investing ahead, you might decide to put more of your money into stocks. If you need the money sooner, you might have a larger percentage of your portfolio in more conservative investments, but keep some stocks for future growth potential.
- Diversification. Put simply, this is a strategy to reduce your risk. Spreading out your investment dollars among different types of industries is wise so that no single investment is likely to have an outsized impact on your entire portfolio.*
- Systematic investing (also called dollar-cost averaging). Historically, we’ve seen that those who invest regular amounts of money at fixed intervals (instead of trying to time investments to when the market is favorable) tend to have portfolios that do better over time. This strategy can help remove the emotion from investing decisions.*
How Much Risk Should You Take?
Figuring out how much risk to take is a big decision, and it’s one that is likely to change as your circumstances change—so you’ll need to reevaluate your plan periodically. You can start by looking at your goals, age and risk tolerance. It’s also important to include other assets and sources of income (pensions, Social Security, etc.) as well as your tax situation.
If you need help getting started, Navy Federal Financial Group advisors will take a comprehensive look at your overall finances and can help you build a personalized investment strategy. If you already have a plan in place, our advisors can help you decide where and when it may need tweaking.
*Neither diversification nor systematic investment can guarantee a profit or protect against loss in a declining market.