Risk and How to Manage it
Here's the big picture regarding investment risk:
- Risk is associated with the uncertainty of an investment’s performance.
- There is generally a correlation between risk and potential reward.
Risk can best be explained as uncertainty and is usually associated with the unpredictability of an investment’s performance. All investments are subject to risk, but some have a greater degree of risk than others. Risk is often viewed as the potential for an investment to decrease in value.
Sources of Risk
Let's break it down now, as there are many sources of investment risk. They include:
- Market risk
- Interest-rate risk
- Inflationary risk
- Exchange-rate risk
- Credit risk
Sources of Risk
Each source of risk contributes to an investment’s potential to change value. For example, if the credit risk of a bond increases, the value of the bond often decreases.
Market Risk is associated with how much an investment's price may move up and down with general market trends.
Interest-Rate Risk is associated with the impact of interest rate changes on the value of an investment. Changes in interest rates often lead to fluctuations in the value of fixed-income investments.
Inflationary risk is usually associated with how fast prices rise. Inflation may erode the value of an investment over time as buying power is reduced. The higher the rate of occurs.
Exchange-rate risk relates to the potential for change in the value of one currency in relation to another. These changes can effect returns dependant on these currency rates.
Credit risk is associated with the potential for nonpayment or default on fixed-income investments.
Risk and Reward
The relationship between risk and reward is a fundamental concept of portfolio planning. Each investment has some level of risk associated with it. Although there are no guarantees of any investment’s results, there is generally a correlation between the potential reward an investment offers and the risk associated with it.
Portfolio Planning: Risk vs. Reward
The degree to which the value of an investment moves up and down is known as its volatility.
To Balance Risk and Reward, Diversify Your Portfolio
One of the most important aspects of managing a retirement portfolio is balancing risk and reward. In general, increasing risk may help you increase reward. But to decide how much risk you are willing to take, you need to be familiar with the different types of risk and how they interrelate.
Principal risk is the type of risk most people think of first. It refers to the possibility that you could lose some of the money you invest—your principal. Usually, investments with a higher degree of principal risk have the potential to yield greater returns over time than investments with lower principal risk.
Fluctuation risk is related to principal risk, but refers specifically to how much the price of an investment may move up or down.
Inflation risk is the one most commonly forgotten. It is the risk that inflation will erode the value of a portfolio. If you try to stay safe by avoiding principal risk in your retirement assets, your returns may not keep pace with the cost of living. Therefore, you face high inflation risk.
One way to keep all three types of risk in balance, and achieve your return goals, is to spread your assets among various investment classes, including stocks, bonds and cash equivalents such as CDs or money market funds. This strategy, called asset allocation, tends to be less volatile than concentration in a single type of investment because different investment classes rarely move in tandem, although securities in a given class tend to follow the same pricing trends. For example, if stocks are down, bonds may be up. With asset allocation declines in one market can be offset by gains in another.
Also, each asset class offers unique protection against risk of one kind or another. Asset allocation lets you take advantage of the potential benefits of each.
Stocks have historically offered the best long-term returns and the most protection from inflation risk, but they carry the most potential for short-term fluctuations. Of course, past performance does not guarantee future results.
Bonds offer current income at a fixed rate. Highly rated bonds protect against principal risk by providing some assurance that you'll retrieve your principal at a given maturity date. You can realize capital gains or losses if you sell before maturity, however, since bond prices fluctuate in response to interest-rate change.
Cash equivalents historically offer a high degree of safety from principal and fluctuation risks, but produce pretax gains just slightly higher than the rate of inflation.
Mutual funds can provide an excellent and easy way to diversify your investments because they are collections of stocks, bonds or other securities managed by a professional fund manager.
The proportions of the investment mix you choose are influenced by your investment objectives and risk tolerance, which are likely to depend on your stage of life. Younger investors, with a longer investment time frame, are generally more aggressive in approach, focusing on growth and willing to accept some principal risk to counter inflation risk. Those approaching retirement may wish to lower principal and fluctuation risk to protect their principal. With a shorter time frame inflation risk is less important, although it should never be ignored.
Diversifying your portfolio is not a once-and-for-all action. Periodically review your strategy with us, as we can provide asset mix guidelines and match your goals with appropriate investment instruments.ď»ż