Few terms in personal finance are as important, or used as frequently, as “risk.” Nevertheless, few terms are as imprecisely defined. Generally, when financial advisors or the media talk about investment risk, their focus is on the historical price volatility of the asset or investment
Every investment carries some degree of risk, including the possible loss of principal, and there can be no guarantee that any investment strategy will be successful. That’s why it makes sense to understand the kinds of risk as well as the extent of risk that you choose to take, and to learn ways to manage it.
• Market risk: This refers to the possibility that an investment will lose value because of a general decline in financial markets, due to one or more economic, political or other factors.
• Inflation risk: Sometimes known as purchasing power risk, this refers to the possibility that prices will rise in the economy as a whole, so your ability to purchase goods and services would decline. Inflation risk is often overlooked by fixed income investors who shun the volatility of the stock market completely.
• Interest rate risk: This relates to increases or decreases in prevailing interest rates and the resulting price fluctuation of an investment, particularly bonds. There is an inverse relationship between bond prices and interest rates. As interest rates rise, the price of bonds falls; as interest rates fall, bond prices tend to rise.
• Credit Risk: This refers to the risk that a bond issuer will not be able to pay its bondholders interest or repay principal.
• Liquidity risk: This refers to how easily your investments can be converted
• Political risk: This refers to the possibility that new legislation or changes in foreign governments will adversely affect companies you invest in or financial markets overseas.
• Currency risk: This refers to the possibility that the fluctuating rates of exchange between U.S. and foreign currencies will negatively affect the value of your foreign investment, as measured in U.S. dollars.
The Relationship Between Risk & Reward
In general, the more risk you’re willing to take on, the higher your potential returns, as well as potential losses. It is simply a fact of life — no sensible person would make a higher-risk investment without the prospect of receiving a higher return. That is the tradeoff. Your goal is to maximize returns without taking on an inappropriate level or type of risk.
Understanding Your Own Tolerance for Risk
The concept of risk tolerance is twofold. First, it refers to your personal desire to assume risk and your comfort level with doing so. If you find that you can’t sleep at night because you’re worrying about your investments, you may have assumed too much risk. Second, your risk tolerance is affected by your financial ability to cope with the possibility of loss, which is influenced by your age, stage in life, how soon you’ll need the money, your investment objectives and your financial goals. If you’re investing for retirement and you’re 35 years old, you may be able to endure more risk because your investments have more time to ride out short-term fluctuations in hopes of a greater long-term return.
Reducing Risk through Diversification
Don’t put all your eggs in one basket. You can potentially help offset the risk of any one investment by spreading your money among several different asset classes. Diversification strategies take advantage of the fact that forces in the markets do not normally influence all types or classes of investment assets at the same time or in the same way. Swings in overall portfolio return can potentially be moderated by diversifying your investments among assets whose values may behave very differently from one another. Diversification cannot guarantee a profit or ensure against a potential loss, but it can help you manage the level and types of risk you face.
No single strategy can reduce every aspect of risk, but you can help to ensure that you are taking an appropriate level of risk by doing your homework and enlisting the services of a qualified Financial Advisor.
Linda Zivney, CRPC
25 NW Irving Ave., Bend
This information was developed by Broadridge, an independent third party. It is general in nature, is not a complete statement of all information necessary for making an investment decision, and is not a recommendation or a solicitation to buy or sell any security. Investments and strategies mentioned may not be suitable for all investors Securities offered through Raymond James Financial Services, Inc., member FINRA/SIPC. Investment advisory services offered through Raymond James Financial Services Advisors, Inc. Zivney Financial Group is not a registered broker/dealer and is independent of Raymond James Financial Services.