Understanding Investment Risk
All investors – be they conservative, moderate or aggressive – need to understand that the level of return they expect to generate is directly related to the amount of risk they are willing to assume – the higher the return, the higher the amount of risk. Regardless of where you put your money, you assume some element of risk. For instance, if you focus solely on keeping your money safe from the possibility of loss, you risk not accumulating enough money to meet your goal. In this case, trying to avoid “market risk” increases your exposure to other types of risk, such as “inflation risk”.
Essentially, you need risk in order to generate the level of return you need to achieve financial independence. However, risk can be managed far more effectively than investment performance. You can’t predict the direction of the financial markets, or which mutual fund will outperform the others; however, you can manage risk and even have it work for you through proper asset allocation and portfolio diversification. While there is no guarantee that a diversified portfolio will enhance overall return or outperform a non-diversified portfolio, by including a mix of assets and securities that act as counterweights to one another, a risk aware portfolio can potentially smooth returns while reducing overall portfolio volatility.
Understanding the different types of risks and how they can individually and collectively impact your long term investment performance is crucial to constructing a well-conceived portfolio that seeks to maximize your returns while reducing your overall risk.
Different Types of Investment Risk
- Market Risk: The risk that most people associate with investing is market risk, the possibility of losing money due to the price fluctuations of the markets. However, losses are only realized if the investment is actually sold.
- Inflation Risk: Many risk adverse investors and savers prefer the safety of savings accounts, CDs and government bonds. The risk they face is that the growth of their secured savings doesn’t keep pace with the rate of inflation.
- Interest Rate Risk: The prices of interest bearing securities, such as government and corporate bonds fluctuate in response to the movement of interest rates. As interest rates rise, the prices of these securities will decline. So, it is still possible to lose money.
- Taxation Risk: Over a long period of time, taxes can impact return on investment. Additionally, tax laws do change, so if an investment is made based on its tax treatment, it could become less advantageous with future tax law changes.
- Liquidity Risk: Investors who are concerned with having immediate access to their money need to be aware of liquidity risk. The safest of investments, such as CDs, have some liquidity risk because if it is redeemed too early, the investor could lose a part of his principal to early redemption fees. And, even though stocks and bonds can generally be liquidated at any time, investors may be reluctant to do so if they are in a loss position.
When investing, all possible risks should be evaluated against your overall tolerance for risk. DWD can help you effectively manage risk by establishing a long-term investment strategy with your specific goals in mind, and by employing a long-term investment horizon to allow your investments to work through the inevitable down and up cycles of any market. You can further minimize investment risks through the broad diversification of assets. It is impossible to predict future market returns, so managing investments based on performance provides very little control over the outcome. However if you seek to manage portfolio risks, long term performance can be improved. DWD can help whatever your tolerance.