Understanding Investment Risk
We all take risks in the hope of gaining something—buying a home, changing careers or going back to school. Investing, like many other things in life, involves risk in order to achieve return. While it's normal to be concerned about the security of your money, a narrow perception of risk can be limiting. In fact, by understanding investment risk and how it relates to potential returns, investors can help strengthen their portfolios and improve their chances for greater wealth.
Many investors view risk as the possibility of losing money, but it's really much more complex. Because of its multifaceted nature, risk can affect your investment in a number of ways. Below, we've identified the most common forms of risk, along with their potential effects on your mutual fund investment.
Economic factors, such as recession, inflation or changing interest rates, can all influence the overall movement of the markets, thus affecting the value of your investment. Also, stock values may fluctuate in response to the activities and financial prospects of an individual company. Because the financial markets are so dynamic, it's normal for your investment value to change on a daily basis. The degree to which your investment value can fluctuate determines how volatile it is.
Some individuals—even those with long-term investment horizons—dislike volatility because they are uncomfortable with short-term swings in value. As a general rule, the greater the volatility of an investment, the greater its potential for higher returns.
The most significant downside risk to your mutual fund investment is not short-term price changes, but that its value will decline at the point you need to sell. So, as you approach your investment goal, it may make sense to shift your portfolio to investments that seek to conserve principal, rather than to grow principal. This can lessen your downside risk in the short run.
Interest Rate Risk
Bond funds are generally perceived to be "safer" than stock funds because they have historically experienced less price volatility. However, individual bonds are issued with a fixed rate of interest, so their values fluctuate in response to changes in current interest rates. When interest rates increase,the value of an existing bond goes down, because it is paying a lower rate than what investors could earn elsewhere. When interest rates decrease, bonds increase in value because they are earning a higher rate than what investors could earn from newly issued bonds. Generally, the longer the maturity of a bond, the greater its degree of interest rate risk.
If the company that issues a bond experiences financial difficulty or fails, bondholders may not be paid the promised interest or the full amount of their principal. This is referred to as credit risk. To help investors understand the extent of credit risk associated with different bonds, third-party organizations such as Moody's Investors Services evaluate and rate bonds. The higher the rating, the higher the quality of the bond. In exchange for greater safety though, higher quality bonds have less return potential. Likewise, lower quality bonds generally pay a higher interest rate to compensate investors for greater credit risk.
Some investors choose investments with fixed or guaranteed interest rates, such as bonds or certificates of deposit, because they desire security of principal. But inflation poses a risk to these investors, because there is a chance that the fixed rate may not keep pace with the rising cost of goods and services over time.
There are a variety of risks involved with international investing. Foreign markets may be less mature and less regulated than US financial markets; the issuer of an international security may be subject to greater political or economic uncertainty, and foreign securities can gain or lose value when converted from one currency to another. However, international investing gives investors the opportunity to participate in a broader range of companies and economies. In many cases, these companies may offer greater potential than US-only investments. Also, a fund that is invested in several different countries can reduce risk through greater diversification.
While awareness of risk can lead an investor to make prudent decisions, it is possible to be overly cautious. "Safe," low-interest cash investments, like money market funds, for example, are excellent choices for preserving assets once you approach or achieve your goal. But over the long-term, they generally cannot provide the capital appreciation needed to meet a significant investment goal. All investments involve risk—but there are strategies that you can follow to manage these risks and pursue your financial goals with more confidence.
Stay the Course
Some investors rush into the market when it is doing well and then unload their shares at the first hint of decline. While it is important to be knowledgeable about market movements, attempting to chase returns can be a risky business. If you have a significant investment goal, you must be willing to commit for the long term. The longer you remain with an investment, the greater its ability to withstand the market's normal fluctuations.
You can offset the risks unique to one investment by simultaneously spreading your dollars among others. This way, you can balance the greater price volatility of stocks, for example, with the more stable, income-generating nature of bonds. This is called diversification. Diversification can also be accomplished by investing broadly within a particular asset—such as exposing the stock portion of your portfolio to different types of stock funds: an international stock fund, a large company stock fund and mid-size company stock fund.
Another effective method of managing risk is to invest regularly—that is, invest a consistent amount every month or quarter, regardless of what is happening in the markets. As prices fall, your regular investment will buy more shares, and when prices rise again, your existing shares will increase in value. Many working individuals have the opportunity to participate in this approach—also called dollar cost averaging*—through their company's retirement plan. Those who contribute with each payroll deduction are already familiar with the discipline and benefits derived from regular investing.
Put Risk In Perspective
Whether you're sampling a cup of steaming coffee or beginning the first day of a new job, you are encountering some form of risk. In the final analysis, only you can decide what you are willing to chance for meaningful rewards. Certainly no one should build an investment portfolio that causes one to lose sleep—you must feel comfortable about your investment objectives and the methods you've chosen to achieve them. Regardless of your investment goals, you can benefit from an understanding of risk. Use proven risk management techniques and commit to your chosen investment plan, and you may find risk to be a valuable ally.