Understanding Investment Risk
There are several types of investment risk, but most people are concerned with market risk, i.e., the possibility that you might not get back the amount you originally invested due to a dramatic decline in stock and bond prices.
All Investments Carry Risk
All investments involve some degree of risk and in choosing between different assets you will be trading off risk for the potential of reward. Therefore, you must know the risk associated with any investment and ensure that it fits into your goals and circumstances. As a general rule, investments that have the highest potential return also carry the greatest level of risk. Risk and reward go hand in hand. For example, concentrating on one stock or one market segment like technology is risky, but it can also be extremely rewarding. In other words, with the chance of hitting it big also comes the potential of losing it all.
There are three primary asset groups: stocks and stock mutual funds, bonds and bond mutual funds, and cash and cash-equivalents like money market mutual funds. Each carries its own level of risk.
Stocks and stock mutual funds as a rule carry the most risk. Bonds and bond funds carry a moderate amount of risk, and cash and cash-equivalents carry the least. But, be careful of this oversimplification. A stock index fund that is broadly diversified across different industries and company sizes can carry less risk than a bond fund in a rising interest rate environment.
Fear and Risk Are Not the Same
Keep in mind that when we talk about risk, we are not talking about fear. Fear is a strong emotion caused by anxious concern over a real or perceived danger. In this case, the danger that brings on the fear is that the money invested will decline in value, even temporarily. The fearful investor is the one who can't sleep at night worrying about whether their principle is going to decline. These investors are often called "risk adverse," but in reality they are just fearful. To overcome their fear, they have to limit investments to bank certificates of deposit, Treasury bills, and money market funds. In truth they are still putting their retirement assets at risk -- inflation risk. This is the risk that your retirement funds will not earn enough to keep up with inflation and therefore have less buying power at retirement than they have today. This risk is most devastating over long periods of time.
Risk Changes With Age and Circumstances
Investing always involves making decisions that balance risk and reward. The decisions you make today may not be appropriate for you later in life. You need to factor in your age, years to retirement, and other circumstances in determining how much risk is suitable for you at any given time. When you are young and unmarried, you can take on more risk than when you are within five years of retiring and have others who are dependent on you. As a 50 year old, safety may appeal to you, but a low return on too-large a portion of your retirement account is unlikely to provide any protection against erosion in purchasing power due to inflation. And if you are within five years of retiring, you should not be taking on large amounts of risk. Instead, your concern should be with the safety of your principle.
Understanding the balance between risk and return on your investments can help you build an investment strategy for your retirement assets that you can live with and benefit from.
This is for educational purposes only. The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.