Risk is the potential for losing money instead of making it, or making less than you had expected. Risk is also the possibility that the value of your return—what you earn plus the change in the value of your investment—will be undermined by inflation, reducing your buying power.
Understanding the risk/return relationship is essential to making rational investment decisions. The more risk you’re willing to take, the greater the potential for a substantial return, but also for experiencing a loss. On the other hand, if you take no risk, you’ll have minimal return, if any.
While certain investments provide minimal return, the tradeoff is that they keep your principal safe. You can be confident that you’ll be able to withdraw your $1,000 investment in a CD at the end of the term. In contrast, at any point, your mutual fund could be worth far less than $1,000. And if you sold it once it declined, you’d have a loss.
Market and Investment Risk
The risk associated with investing typically fits into one of two categories:
Market risk that results from what’s happening in the financial markets as a whole—for example, the extraordinarily weak economy in 2008 and 2009.
Investment risk that occurs when an individual investment loses value for reasons directly related to the investment itself—for example, poor management or overly strong competition.
Strategies to Manage Risk
While all investments carry some risk, there are three ways to mitigate that risk: asset allocation, diversification, and cost control. While these strategies don’t guarantee success or protect you from losses,they can help to manage risk while maintaining the potential for a strong return.
Using asset allocation, you divide your investment principal among several different types of investments, or asset classes, on a percentage basis, rather than putting all your proverbial eggs into one basket.
Different asset classes—equities, fixed income, cash equivalents, and real estate—generally react differently to what’s happening in the economy at any given time. Asset allocation lets you offset losses in one class with gains in another and also helps you take advantage of the ever-changing markets by having some investments in every asset class every year.
Asset allocation helps you manage market risk. You can help manage investment risk by diversifying, or investing in several investments within each subclass of an asset class.
For example, a large-company stock and a small-company stock are both equities, but belong to different subclasses.
Asset subclasses tend to differ from each other in some important ways—for example, a large-company stock and a small-company stock tend to increase in value at different rates, react differently to changes in the economy, and expose you to different levels of investment risk.
Your equity portfolio is diversified if you own three or four mutual funds that make different types of investments—for example, an index fund that tracks large-company stocks, a second index fund that tracks small-company stocks, and a third that tracks international stocks in developed countries. And your fixed income portfolio is diversified if you own some corporate bonds, some municipal bonds, and some Treasuries.
You’re not diversified if you own just a handful of stocks, or shares of a mutual fund that is concentrated in one financial sector, or if the bonds you own are all issued by the state in which you live.