When you invest, you incur risk – there’s no avoiding it. But the concept of “risk” may be more expansive than you realized. And by understanding the different types of investment risk and how these risks can be addressed, you can improve your skills as an investor.
The most common perception of investment risk is simply the risk of losing money. When you invest in stocks and stock-based vehicles, such as mutual funds, there are no guarantees that your principal – your initial investment amount – will be preserved. Generally speaking, if you hold stocks or mutual funds over a period of years, and even decades, you can reduce the likelihood of sustaining losses that could send your investments’ value to zero. Hopefully, the value of your investments will rise over time. And it’s worth noting that, since the Great Depression, U.S. stocks have averaged 9.59% annual returns, according to Morningstar Direct, an investment research service. However, past performance can’t guarantee future results.
In any case, this type of risk is real, and it’s a factor to consider when making your investment decisions. But you can’t avoid all risk by avoiding stocks and putting your money into other types of investments. Consider bonds, for example. When you purchase a bond, you typically receive regular interest payments and you get back your initial investment when the bond matures, provided the issuer doesn’t default. But if interest rates go up and you want to sell your bond before it matures, you’ll have to offer it at a “discount,” because no one will pay the full price for your bond when they can buy new ones at a higher rate.
You can help manage this type of interest rate risk by owning a variety of bonds with different maturities. When interest rates are rising, you can reinvest your short-term bonds at the new, higher rates. And in a falling-rate environment, you can still benefit from your longer-term bonds, which typically pay higher interest rates.
Foreign or international investments also contain specific risks. When you purchase foreign stocks, you’ll find that fluctuations in the value of currencies relative to the U.S. dollar can affect your returns. Also, international investments may carry political risk, since some foreign governments and political systems may change in ways that work against businesses in those countries. To contain these types of risk, you’ll want to maintain an appropriate allocation of international holdings and diversify across regions.
Ultimately, your most broad-based defense against all types of risk is to build a diversified portfolio containing U.S. stocks, international stocks, corporate bonds, mutual funds, government securities and other investments. Diversification works because it helps reduce the impact that market volatility can have on your portfolio if you only own one type of asset, such as domestic stocks. (However, diversification can’t guarantee profits or protect against all losses.) And you’ll also want your portfolio to reflect your individual tolerance for risk.
By being aware of the different types of risk, and taking steps to mitigate them, you can create a strategy that offers the potential to help you achieve your important goals, such as a comfortable retirement. And by doing so, you’ll avoid the greatest risk of all: not investing for your future.
This article was written by Edward Jones for use by your local Edward Jones Financial Advisor. Edward Jones, Member SIPC
This article originally appeared on Evening World: Financial Focus: What should you know about investment risk?