6 Types of Investment Risk and StrategiesSubmitted by The Participant Effect on July 19th, 2018
We’d all love to reap the rewards of high returns on our investments without risk. But unfortunately, wishing does not make it so. Like it or not, risk is part of the equation if you’re aiming for anything other than preservation of capital — a risky goal in and of itself, since the buying power of your money will slowly erode over time if you don’t outpace inflation. The good news is that there are many ways to manage different types of investment risks.
1. Market Risk. Stock prices rise and fall over time, sometimes dramatically. While this can be thrilling in the case of a run up, it can be stomach churning when prices fall precipitously. Other asset classes are not immune to market risk as the price of bonds, real estate, gold and other commodities can fluctuate as well. However, diversification among stocks, bonds and other asset classes can help balance market risk. Losses on paper are realized only when you actually sell, so take steps to avoid being forced into selling into a down market. Adjusting allocations as you approach retirement or any other need for divestment is another way you can potentially reduce the impact of market risk.
2. Inflation Risk. As alluded to earlier, inflation can eat away your purchasing power over time. Today, many savings accounts don’t even keep pace with inflation — meaning a negative real rate of return on your money. Additionally, while higher inflation generally goes hand-in-hand with more favorable savings account rates, if your money is locked up in a lower-interest/longer-term CD as rates climb, you can fall prey to the deleterious effect of inflation. Ironically, in this case, risk can potentially help offset risk as often the only way to outpace inflation involves taking on higher risk through greater exposure to equities (and subsequent market risk).
3. Mortality Risk. There are really two types of mortality risk. One is not living long enough, and the other is living longer than you expect (yes, this can actually present a problem despite the obvious benefits). In the case of annuities, there’s the possibility that you don’t live long enough for your premium payments to be worthwhile. For the risk of greater-than-expected longevity, proper planning can go a long way. Target date funds, where assets are rebalanced periodically according to a specific retirement goal date, strive to keep your portfolio appropriately positioned as you approach retirement and can potentially help manage the risk of losses associated with an untimely exit from the market. The principal value of a target date fund is not guaranteed at any time, including at the target date.
4. Interest Rate Risk. The Federal Reserve recently raised interest rates (the principal value of a target date fund is not guaranteed at any time, including at the target date) for the second time this year and signaled two more increases were coming. While this most recent move wasn’t a surprise, it’s expected to impact investors and many individuals who carry debt. New and adjustable rate mortgages are predicted to rise along with credit card rates. This move by the Fed will also likely affect bond prices negatively. Maintaining a portfolio that includes investments that typically benefit in a rising interest rate climate and avoiding excessive exposure to longer term fixed-rate bonds are both strategies to help manage this type of investment risk.
5. Liquidity Risk. Liquidity, or having immediate access to funds, is an important aspect of investment planning. You never want to be in a position where the need to withdraw funds forces you to incur losses or other penalties. An emergency fund is a good example of the need for liquidity since you never know exactly when disaster may strike. This risk can be mitigated through thoughtful asset allocation that maintains an appropriate cash position at all times.
6. Inertia Risk. This is the risk of doing nothing. And it’s particularly detrimental for younger investors who may benefit most from the effects of compounding. The earlier you start saving, the better your chances of positioning yourself for a comfortable retirement. So especially if you’re young and haven’t already started contributing to your 401(k), the time to start is now.
Be aware of risk when in comes to your investments, but there’s no need to be terrified. There are many ways to manage investment risk so you have the potential to grow your nest egg with confidence. Schedule a meeting with your 401(k) advisor to discuss how to address risk to your portfolio so you can pursue the retirement of your dreams.
Disclaimer: Investing involves risk, including possible loss of principal. No strategy assures success or protects against loss.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
Asset allocation and diversification do not protect against market risk. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio.
The fast price swings in commodities and currencies will result in significant volatility in an investor’s holdings.
Investing in real estate involves special risks such as potential illiquidity and may not be suitable for all investors.
CDs are FDIC insured to specific limits and offer a fixed rate of return if held to maturity. Annuities are not FDIC insured. Annuities are long-term, tax-deferred investment vehicles designed for retirement purposes. Gains from tax-deferred investments are taxable as ordinary income upon withdrawal. Withdrawals made prior to age 59 ½ are subject to 10% IRS penalty tax. Surrender charges apply. Guarantees are based on the claims paying ability of the issuing insurance company.
The opinions voice in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult an advisor prior to investing.