The word “risk” is not something that conjures up a pleasant image in the minds of most investors. Many people don’t like risk. Unfortunately, risk is unavoidable. If you invest for profit, you face the possibility of suffering a loss; and if you invest too cautiously, you run the risk of earning a return that will not keep pace with inflation.
One of the best ways to become comfortable with risk is to take the time to understand it. The more familiar you are with it, the better position you will be in to create the proper balance between risk and potential reward in your portfolio. Below is a description of five distinct types of risk that you can face as an investor and how to deal with each:
Market risk refers to the fact that your investment could go down in value and, therefore, be worth less than your purchase price. Any number of factors can affect an investment’s valuation. For example, disappointing earnings can cause a company’s stock price to decline. Rising interest rates can trigger a drop in the price of a bond.
The best way to reduce the effect of market risk in your portfolio is to diversify your assets among securities that are likely to perform differently in the same market environment. In this way, the positive performance of one security can help to offset the negative performance of another.
A good first step in creating a diversified portfolio is to spread assets among stocks and bonds or the mutual funds that invest primarily in these securities. While past performance is no guarantee of future results, stocks and bonds often perform differently under the same market and economic conditions.
For example, if the economy shows strength after a period of weakness, stocks tend to do well, but bond prices tend to fall because interest rates usually get higher. Similarly, when interest rates decline on economic weakness, bonds typically do well, but stocks tend to fall as investors become concerned about the overall outlook for corporate earnings.
Although diversification can help limit risk, it can also limit your potential for gains. For example, if the stock market soars, you could enjoy large gains if you had a substantial portion of your portfolio in equities. But if most of your assets were spread across a wide range of non-equity-related investments, your gains may be limited. This strategy does not guarantee a profit or protect against loss.
Industry risk refers to the risk you face when you invest in a particular sector of the economy. For example, if you invest primarily in one sector, you could do well if that industry outperforms most other industries, but your portfolio could be severely affected if that group falls out of favor with investors.
A good example of industry risk is what took place in the technology sector during and after the infamous “bubble.” After experiencing strong growth throughout the last half of the 1990s, technology stocks fell sharply during the first three years of this decade, creating significant losses for investors who were heavily exposed to this sector.
One of the best ways to deal with industry risk is to invest your assets across several industries. By doing so, you can enjoy the key benefit of diversification—the positive performance of one industry group can help to offset the negative results of an under-performing sector.
Company risk refers to the concept that your assets may decline because a significant portion of your portfolio is invested in the stock of one company. This is a risk often faced by employees whose net worth is largely tied up in their employer’s company stock.
Diversification can be the key to limiting the risk of investing mainly in one company. Focusing on high-quality companies should be another part of this strategy. Generally, the stocks of high-quality, well-established companies (e.g. blue chips) tend to carry less risk than those of small, emerging growth companies.
Inflation risk refers to the idea that the return from an investment may be less than the inflation rate—the increase in the cost of living. While earning a return that is lower than inflation may not appear to be significant, it could prove hazardous to your financial health if it occurs over a period of years.
This is because when you earn a return that is lower than inflation, your dollars lose purchasing power. This means you will need to spend more money to buy the same amount of goods and services that you bought in the previous year. If this trend continues over time, it could affect your standard of living.
To counter inflation risk, you need to buy securities with the potential to deliver returns that exceed the increases in the cost of living. Although past performance is no guarantee of future results, equities have had the best record of outpacing inflation since 1926, according to Ibbotson Associates, Inc., a Chicago-based research firm.
Interest Rate Risk
The valuations of fixed-income investments, such as bonds and preferred stock, are affected by interest rates. When rates rise, overall valuations of fixed-income securities usually decline. Conversely, when interest rates decline, valuations of fixed-income securities typically rise.
The degree by which fixed-income securities are affected by interest rates usually depends on their maturity (the number of years before principal is supposed to be returned to the investor). Generally, short-term, fixed-income securities are less affected by interest-rate movements than long-term, fixed-income securities.
A good strategy to limit interest-rate risk is known as laddering. Laddering is the process of investing assets in fixed-income securities with varying maturity dates, such as every year or every other year—whatever timeframe works well for you. You can spread your investments over five years, ten years—again, any timeframe that you like or that makes sense for your situation. With laddering, you continually have money coming due that can be re-invested at the different rates. As a result, laddering enables you to avoid investing all of your money when rates are at their lowest.
The risks I’ve mentioned exist every day of our lives. As you know, we are living in times with a few very specific risks. We have economic, interest rate and geopolitical events affecting our daily lives and our investments. These may impact decisions in the short-term—just another reason why…
It is always a good idea to speak with a financial advisor about the types of risks inherent in investing. He or she can also help you make decisions to help create the proper balance between risk and potential reward in your portfolio. TPW