All investments come with some degree of risk. Whether you’re investing in stocks, bonds, mutual funds, or exchange-traded funds, there’s always the possibility of losing value, or even your entire investment, if market conditions turn sour. Even seemingly safe investments like bank-issued certificates of deposit (CDs) can be risky due to inflation, as they may not keep up with the rising cost of living.
What Is Risk?
When you invest, you’re making decisions about how to allocate your financial assets. Risk refers to any uncertainty that has the potential to negatively impact your financial well-being. There are various types of risks associated with investments.
Market risk, for example, is the risk of your investment value fluctuating due to market conditions. Business risk arises from corporate decisions that can affect the value of your investments, such as expanding into new areas or merging with other companies. If you have international investments, events within those countries can introduce political and currency risks.
There are also other factors to consider, like liquidity risk, which refers to how easy or difficult it is to cash out your investments when you need to. Concentration risk comes into play when you have too many or too few investments, as having all your money in a single stock can increase the level of risk.
In summary, risk is the possibility of a negative financial outcome that matters to you.
Risk and Reward
The level of risk associated with an investment or asset class usually correlates with the potential return on investment. The underlying idea is that investors willing to take on more risk should be rewarded accordingly.
You can learn about specific risks associated with various investments by reviewing the Risk tab for each investment listed in our Investment Products section.
In the context of investing, reward refers to the possibility of higher returns. Historically, stocks have provided the most significant average annual returns over the long term, followed by corporate bonds, Treasury bonds, and cash equivalents like short-term Treasury bills. However, with higher returns come greater risks.
It’s important to note that stocks don’t always outperform bonds, nor are bonds always less risky than stocks.
Time Can Be Your Friend or Foe
Based on historical data, holding a diversified stock portfolio over an extended period typically reduces the chances of losing your principal. However, historical data shouldn’t lead investors to believe that investing in stocks over the long term carries no risk.
For example, let’s say you invested $10,000 in a diversified stock portfolio that grew to $20,000 after 19 years. However, during a market downturn in the following year, your portfolio loses 20% of its value, or $4,000. As a result, at the end of the 20-year period, your portfolio only amounts to $16,000 instead of the $20,000 you had after 19 years. Stocks can be risky investments, even over the long term, and they don’t become safer the longer you hold them.
This is not a hypothetical risk. If you had planned to retire during the 2008-2009 market downturn, where stock prices dropped by 57%, and had a significant portion of your savings in stocks or stock mutual funds, you would have had to reconsider your retirement plans.
Investors should also consider whether they can withstand the ups and downs of the market in the long run. Will they need to sell stocks during an economic downturn due to a job loss? Will they have to sell investments to cover medical expenses or their child’s college education? Predictable and unpredictable life events can make it challenging for some investors to stay invested in stocks over the long term.
Managing Risk
While you can’t eliminate investment risk entirely, there are two key strategies that can help manage both systemic risk (affecting the entire economy) and non-systemic risk (affecting specific parts of the economy or individual companies): asset allocation and diversification.
Asset allocation involves spreading your investments across different asset classes, such as stocks, bonds, and cash. This strategy helps mitigate the impact of any single investment’s poor performance on your overall portfolio.
Diversification, on the other hand, involves spreading your investments within each asset class. For example, instead of investing all your money in a single stock, you diversify by investing in multiple stocks across different industries. Diversification can help reduce concentration risk.
Hedging and insurance products can provide additional ways to manage risk. However, it’s essential to consider that these strategies often come with added costs, which can eat into your investment returns. Additionally, hedging usually involves more speculative and higher-risk activities, such as short selling and trading complex options or illiquid securities.
In conclusion, all investments carry some level of risk. By understanding the nature of risk and taking steps to manage it, you can position yourself better to achieve your financial goals.
For more information on key investing topics, visit our investment page.
