If you mention risk in today’s tumultuous market climate, most people probably think of their rapidly shrinking investment accounts. But in reality, investment risk takes many forms, and each can affect how you pursue your financial goals. Familiarizing yourself with the different kinds of risk is the first step in learning how to manage risk within your portfolio.
Types of Risk
There are several types of risk of which you should be aware.
- Market risk: The likelihood that the value of a security will move in tandem with its overall market. For example, if the stock market is experiencing a decline, the stocks in your portfolio may decline as well. Or if bond prices are rising, the value of your bonds may also go up.
- Interest Rate risk: Most often associated with fixed-income investments, this is the risk that the price of a bond will fall with rising interest rates.
- Inflation risk: This is the risk that the value of your portfolio will be eroded by a decline in the purchasing power of your savings, as a result of inflation. Inflation risk needs to be considered when evaluating conservative investments, such as bonds and money market instruments as long-term investments. While your investment may post gains over time, it may actually be losing value if it does not at least keep pace with the rate of inflation.
- Credit risk: This type of risk comes into play with bonds. It refers to a bond issuer’s ability to repay its debt as promised when the bond matures. Bonds are given credit ratings by agencies such as Moody’s and Standard & Poor’s. In general, the higher the rating, the lower the credit risk. Junk bonds, which are not investment grade securities generally have the lowest ratings, are among the riskiest in terms of credit. People who invest in them typically seek higher yields to compensate for their higher credit risk.
- International risk: International investments also involve additional risks, including the possibility of fluctuating currency values and the risk that political and economic upheavals may affect a country’s markets.
Manage Market Risk by Diversifying
While there is no guarantee that a diversified portfolio will outperform one not diversified, or that diversification will eliminate market risk all together, spreading your investment dollars across several different investments and investment classes can (in most cases) help to minimize market risk in a portfolio. Selecting investments from more than one asset class can also carry potential benefits. For instance, when stocks are particularly hard hit due to changing conditions, bonds may not be as dramatically affected.
Match Investment Choices to Your Goals
Before you can decide what investment types are appropriate from a risk perspective, you need to evaluate your investment goals. Is your goal principal preservation? Income generation? Building the value of your principal above inflation? Perhaps a combination?
Next, examine your investment time horizon. The longer your time horizon, the more volatility your portfolio may be able to tolerate. If you have a long-term plan, weighing your portfolio heavily in stocks, whose historical long-term returns typically outpace inflation, balanced with some funds dedicated to bonds and money market investments could be appropriate if you’re comfortable with possible short-term losses. On the other hand, if you are a retiree relying heavily on the income from your portfolio, weighing your investments more in stable bonds with a mix of a few stocks to maintain growth potential could be a good strategy to maximize income while minimizing the risk of short-term losses.
However you choose to plan for your future, the important thing to remember is the more you understand risk, the better equipped you’ll be at using it as a tool to help you reach your investment goals.
This article is not intended to provide specific investment or tax advice for any individual. Consult your financial advisor, your tax advisor or me if you have any questions. Securities Offered through LPL Financial | Member FINRA/SIPC – Not NCUA Insured | No Credit Union Guarantee/May Lose Value | LPL Financial is not affiliated with the credit union.