In life, you can't avoid all risks, and you shouldn't try, because endeavors that carry risk also bring the prospect of reward. Many of you reading this are business owners and entrepreneurs and have no doubt spent a great deal of time evaluating risk factors of your various pursuits.
It's the same in the investment world. Instead of trying to invest risk-free, which is impossible, learn to recognize the different types of investment risk while becoming familiar with your own risk tolerance.
To start with, let's quickly look at some of the most common forms of investment risk:
• Risk of losing principal, This is the type of risk most commonly associated with investing. You could lose some, or even all, of your principal if you sell an investment, such as a stock, whose value has dropped lower than the purchase price. You can't eliminate the risk of losing principal, but you may be able to reduce it by buying quality stocks and holding them long enough to overcome short-term market drops.
• Inflation risk, With an investment that pays a fixed rate of return, such as a certificate of deposit (CD), you run the risk of not keeping up with inflation, which means you could lose purchasing power over time. Consequently, it's a good idea not to overload on these types of investments.
• Interest-rate risk, When you own a bond, your investment is somewhat at the mercy of changing market interest rates. For example, if you buy a bond that pays four percent interest, and market rates rise so that newly issued bonds pay five percent, the relative value of your bond will go down; no one will pay you face value of your bond when they can get new ones that pay higher rates. Of course, if you hold your bonds until maturity, which is often a good idea, you can avoid being victimized by interest-rate risk.
• Concentration risk, This type of risk occurs when you have too much of your money concentrated in one area, such as in a particular stock or in one industry. If a downturn strikes that stock or industry, your portfolio could take a big hit. To combat this type of risk, you need to diversify your holdings. While diversification cannot guarantee a profit or protect against a loss, it can help reduce the effect of volatility.
• “Lack of Plan” risk — Ok, so I made this one up, it is not an investment risk. However, if I asked you right now to run and produce for me your family's written document that illustrates how you will reduce today's and tomorrow's tax obligation, how you will put your children through college, yourself through retirement and how, if necessary, you will care for aging parents–could you? I salute those who have taken the time to sit with a professional and produce such reports and implore those who have not to ask themselves 'why?'
In addition to understanding the above types of risk, you also need to be familiar with your own risk tolerance and how it affects your investment strategy. If you are constantly worried about the market, you've probably got too many investments that are at risk of losing principal.
At the other end of the spectrum, if you're always concerned that your portfolio won't grow enough to generate the income you'll eventually need for retirement, you may be investing too conservatively, and, as a result, you're inviting inflation risk. Frequently, investors need to also recalibrate what they perceive as risk, and this is rarely done well without professional help.
Ultimately, you need to match your own risk tolerance with a strategy that allows you to achieve your goals. This will require self-awareness, patience, discipline, and, at times, a willingness to move outside your own comfort zone. By learning to balance and manage risk, you can ultimately put yourself in a position to pursue your investment strategy.
It's the same in the investment world. Instead of trying to invest risk-free, which is impossible, learn to recognize the different types of investment risk while becoming familiar with your own risk tolerance.
To start with, let's quickly look at some of the most common forms of investment risk:
• Risk of losing principal, This is the type of risk most commonly associated with investing. You could lose some, or even all, of your principal if you sell an investment, such as a stock, whose value has dropped lower than the purchase price. You can't eliminate the risk of losing principal, but you may be able to reduce it by buying quality stocks and holding them long enough to overcome short-term market drops.
• Inflation risk, With an investment that pays a fixed rate of return, such as a certificate of deposit (CD), you run the risk of not keeping up with inflation, which means you could lose purchasing power over time. Consequently, it's a good idea not to overload on these types of investments.
• Interest-rate risk, When you own a bond, your investment is somewhat at the mercy of changing market interest rates. For example, if you buy a bond that pays four percent interest, and market rates rise so that newly issued bonds pay five percent, the relative value of your bond will go down; no one will pay you face value of your bond when they can get new ones that pay higher rates. Of course, if you hold your bonds until maturity, which is often a good idea, you can avoid being victimized by interest-rate risk.
• Concentration risk, This type of risk occurs when you have too much of your money concentrated in one area, such as in a particular stock or in one industry. If a downturn strikes that stock or industry, your portfolio could take a big hit. To combat this type of risk, you need to diversify your holdings. While diversification cannot guarantee a profit or protect against a loss, it can help reduce the effect of volatility.
• “Lack of Plan” risk — Ok, so I made this one up, it is not an investment risk. However, if I asked you right now to run and produce for me your family's written document that illustrates how you will reduce today's and tomorrow's tax obligation, how you will put your children through college, yourself through retirement and how, if necessary, you will care for aging parents–could you? I salute those who have taken the time to sit with a professional and produce such reports and implore those who have not to ask themselves 'why?'
In addition to understanding the above types of risk, you also need to be familiar with your own risk tolerance and how it affects your investment strategy. If you are constantly worried about the market, you've probably got too many investments that are at risk of losing principal.
At the other end of the spectrum, if you're always concerned that your portfolio won't grow enough to generate the income you'll eventually need for retirement, you may be investing too conservatively, and, as a result, you're inviting inflation risk. Frequently, investors need to also recalibrate what they perceive as risk, and this is rarely done well without professional help.
Ultimately, you need to match your own risk tolerance with a strategy that allows you to achieve your goals. This will require self-awareness, patience, discipline, and, at times, a willingness to move outside your own comfort zone. By learning to balance and manage risk, you can ultimately put yourself in a position to pursue your investment strategy.