Understanding Risk
All investments involve risk it is just a matter of to what degree. One way to reduce your risk is to Diversify.What is Risk?
Risk can be summarized as the fluctuations in the return on your investment — not the possibility that you will lose all your money in one fell swoop. Investments are divided into “safe” and “risky” categories. Your risk tolerance or your attitude towards risks and safety is an important part of your profile. Regardless of your financial status, risk tolerance should always shape your portfolio. Some questions to ask yourself include:
- How much of a loss can I tolerate?
- What are my liquidity requirements?
- What is my time horizon? Short-term or long-term?
- What are my expectations regarding my investment returns?
Where does Risk come from?
Business risk. A company may fall on hard times, having a negative affect on its stock prices. In the worst case scenario the company could go out of business, leaving the stock or bond you hold worthless.
Market risk. Sometimes no matter how well a company is doing, its price can be affected by a general decline in the stock market. Both stocks and bonds involve some degree of market risk, which is the risk that investors may lose some of their principal due to price volatility in the overall market. Bond prices fluctuate with changing interest rates. An inverse relationship between bond prices and bond yields exists; as bond yields rise, bond prices decline, and vice versa.
Interest rate risk. This is the sensitivity of an investment’s value to fluctuations in interest rates. The term is generally associated with bonds because bond prices change with interest rate movements.
Inflation risk. This is also known as purchasing power risk. It is the effect of continually rising prices on investments. An investor who buys a bond or fixed annuity may be able to purchase far less with their money when the investment matures. If your investment is growing at less than 3-4 percent, which is the average rate of inflation, you will end up poorer in terms of actual buying power.
Capital risk.This is the potential for an investor to lose all money and invested capital under circumstances unrelated to an issuer’s financial strength. An example would be when an option expires out-of-the-money.
Liquidity risk. This is defined as the risk that a client may not be able to sell his/her investment quickly at a fair market price.
Reducing Risk
All investments involve risk. It is just a matter of to what degree. One way to reduce your risk is to diversify. Diversifying means owning stocks, bonds and other assets. Though diversification doesn’t guarantee that you won’t lose money, it can certainly even out the rise and the fall in the value of your portfolio.
The key component here is to acquire a mix of assets whose price movements don’t mirror each other too closely or, as it is called, negative correlation. When one type of assets does poorly, another type usually does well. Remember, it is important to select assets that are aimed at meeting your goals, timeline and risk comfort zone.
Let’s look at two examples how risk and return work together and what that means for you.
- A risk-adverse investor has an asset allocation whose value is relatively stable. The assets will neither increase greatly nor decrease greatly. A good rule of thumb for the range of movement in the value of the portfolio is up 5% to down 5%. This type of investor would likely be more interested in an income allocated portfolio.
- An investor with a high risk tolerance may have an asset allocation whose value increases dramatically or falls dramatically. A good rule of thumb for the range of movement in this portfolio would be up 20% or down 20%. This type of investor would likely be more interested in a growth allocated portfolio.
Remember, an individual’s risk tolerance varies by personality and other factors, such as time horizon, age and income needs.
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