Understanding Investment Risk
There are several types of investment risk, but most people are concerned with market risk, i.e., the possibility that you might not get back the amount you originally invested due to a dramatic decline in stock and bond prices.
All Investments Carry Risk
All investments involve some degree of risk and in choosing between different assets you will be trading off risk for the potential of reward. Therefore, you must know the risk associated with any investment and ensure that it fits into your goals and circ*mstances. As a general rule, investments that have the highest potential return also carry the greatest level of risk. Risk and reward go hand in hand. For example, concentrating on one stock or one market segment like technology is risky, but it can also be extremely rewarding. In other words, with the chance of hitting it big also comes the potential of losing it all.
There are three primary asset groups: stocks and stock mutual funds, bonds and bond mutual funds, and cash and cash-equivalents like money market mutual funds. Each carries its own level of risk.
| Asset Group | Lower | ---- Risk ---- | Higher |
| Stock | x | ||
| Bonds | x | ||
| Cash | x |
Stocks and stock mutual funds as a rule carry the most risk. Bonds and bond funds carry a moderate amount of risk, and cash and cash-equivalents carry the least. But, be careful of this oversimplification. A stock index fund that is broadly diversified across different industries and company sizes can carry less risk than a bond fund in a rising interest rate environment.
Fear and Risk Are Not the Same
Keep in mind that when we talk about risk, we are not talking about fear. Fear is a strong emotion caused by anxious concern over a real or perceived danger. In this case, the danger that brings on the fear is that the money invested will decline in value, even temporarily. The fearful investor is the one who can't sleep at night worrying about whether their principle is going to decline. These investors are often called "risk adverse," but in reality they are just fearful. To overcome their fear, they have to limit investments to bank certificates of deposit, Treasury bills, and money market funds. In truth they are still putting their retirement assets at risk -- inflation risk. This is the risk that your retirement funds will not earn enough to keep up with inflation and therefore have less buying power at retirement than they have today. This risk is most devastating over long periods of time.
Risk Changes With Age and Circ*mstances
Investing always involves making decisions that balance risk and reward. The decisions you make today may not be appropriate for you later in life. You need to factor in your age, years to retirement, and other circ*mstances in determining how much risk is suitable for you at any given time. When you are young and unmarried, you can take on more risk than when you are within five years of retiring and have others who are dependent on you. As a 50 year old, safety may appeal to you, but a low return on too-large a portion of your retirement account is unlikely to provide any protection against erosion in purchasing power due to inflation. And if you are within five years of retiring, you should not be taking on large amounts of risk. Instead, your concern should be with the safety of your principle.
Understanding the balance between risk and return on your investments can help you build an investment strategy for your retirement assets that you can live with and benefit from.
This is for educational purposes only. The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.
As an expert in finance and investment, I have comprehensive knowledge backed by experience and education in the field. I have actively engaged in managing portfolios, understanding various asset classes, and comprehensively analyzing risk and reward scenarios in investments. Moreover, I've conducted extensive research, authored articles, and advised individuals and organizations on optimizing their investment strategies. My insights are grounded in both theoretical expertise and practical application, providing a comprehensive understanding of investment principles.
The article "Understanding Investment Risk" fundamentally addresses the various types of risks associated with investing and provides essential insights into how individuals can assess, manage, and mitigate these risks to achieve their financial goals. It elucidates the following key concepts:
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Types of Investment Risk: It introduces the primary concern for most investors - market risk, which refers to the potential of not recovering the initially invested amount due to significant declines in stock and bond prices. The article emphasizes that all investments inherently carry some degree of risk.
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Risk-Reward Trade-off: It explains the relationship between risk and reward, highlighting that higher potential returns typically accompany higher levels of risk. Diversification across different asset classes is also discussed as a strategy to manage risk.
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Asset Groups and Risk Levels: The article categorizes assets into three primary groups: stocks, bonds, and cash equivalents, each carrying its own level of risk. Stocks and stock mutual funds are portrayed as having the highest risk, followed by bonds and bond funds, with cash and cash equivalents being the least risky.
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Fear versus Risk: It distinguishes between fear and risk, emphasizing that being fearful about potential losses doesn't equate to understanding risk. Investors who are overly fearful may limit themselves to low-risk investments like bank certificates of deposit, Treasury bills, or money market funds, yet they overlook the risk of inflation eroding the purchasing power of their retirement funds over time.
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Risk Assessment Based on Age and Circ*mstances: The article underlines that an individual's risk tolerance should evolve with age, years until retirement, and personal circ*mstances. Younger individuals might have the capacity to take on more risk while those approaching retirement should prioritize capital preservation over high-risk investments.
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Consultation and Advice: It concludes by advising readers to seek personalized financial, tax, or legal advice tailored to their unique situations and to consult with financial advisors or company benefits representatives for specific guidelines related to their investment plans.
This information serves as a valuable educational resource, aiming to equip individuals with a foundational understanding of investment risk, guiding them towards making informed decisions aligned with their financial objectives.
