Understanding investment risk
Risk is part of everyday life and in the world of investments there are various risks that should be understood as a wise investor. Knowing and understanding risk will never completely eliminate risk, but will help in making informed decisions. Managing investment risks takes into consideration your financial goals, understanding your personal comfort level and a well-rounded financial plan.
Among the various risks that should be understood as part of any financial planning program and goal setting are the following:
- Inflation risk is the risk that your purchasing power will not keep up with inflation.
- Credit risk is the possibiilty that a bond issuer will be unable to make timely payments of principal and interest/
- Liquidty risk is the possibility that you will not be able to sell and investment when you want, or need, to.
- Volatility risk is the possibility that an investment may experience dramatic short-term price fluctuations.
- Reinvestment risk is usually associated with bonds and is the possibility that you will not be able to reinvest your principal or earnings at the same rate as you had in the past.
- Market, or systemic, risk is the risk that you will lose money on a stock or bond because of market or economic events that are well beyond your control.
- Shortfall risk is the possibility that you will not save enough to meet your financial goals.
There are many issues concerning personal risk tolerance including both an ability and a willingness to take risks. The ability to take risks is dependent on your goals and resources, wherein the chance that a loss will affect on your lifestyle must be taken into consideration in evaluating the risk for an investment. The willingness to take a risk is related to your tolerance to withstand significant changes in market conditions and either look at major price declines as an opportunity or a time to sell to avoid further losees. There is no right or wrong to such tolerance, but personal tolerance must be understood.
While no strategies to manage risk is foolproof, there are steps that can be considered to control personal risk tolerance, including the following general strategies:
- Personal savings and spending rates can be adjusted periodically to help achieve goals.
- Asset allocation can help control exposure to market risk by decreasing exposure to stocks, for example.
- Diversification can help manage the exposure to volatility risk by maintaining a well-diversified portfolio, possibly including mutual funds.
- Time frame adjustments, such as deferring retirement or delaying the purchase of a major asset, can help to achieve goals.
- Investing with short-term money needs in mind, liquidity risk can be minimized by keeping necessary reserves in easily accessed, non-volatile investment vehicles such as money-market funds.
Your investment professional can help explain the issue of risk and possibly help you determine your personal risk tolerance.
