Risk is a complex concept, but understanding the basics—and knowing your comfort level—can help shape your investment strategy.
Risk, and the role it plays in a portfolio, can be among the most difficult concepts to understand fully. Sometimes our view of risk isn’t something we consider until there’s a sharp market downturn, such as the one triggered by the novel coronavirus. To help bring the positives and negatives of risk into clearer focus, here are four important risk-related considerations for every investor.
1. Risk has many faces
The term “risk” usually refers to investment risk: the idea that you could purchase stock at $50 a share and it could be worth $25 a year later. This kind of risk is relatively easy to understand, and it’s measurable based on the ups and downs in a single investment’s price. The more volatile the price has been, the more risky the investment is considered to be.
Investment risk is only one risk investors can face. Others include:
- Market risk. This is the risk that the entire market will decline and pull your investment down with it. This happened to stocks during the Great Recession, as well as during the recent market decline due to the impact of the coronavirus pandemic.
- Inflation risk. Inflation is the overall increase in prices in an economy. There’s a risk that an investment’s return won’t be enough to overcome inflation’s impact. For example, if inflation runs 2% a year and your investment returns only 1%, your investment will buy less at the end of the year than at the beginning.
- Opportunity risk. Some investors believe you can avoid risk by investing conservatively. Opportunity risk is the possibility of missing out on the chance to earn better returns because you aren’t being more aggressive.
There are other types of risk, too, including some specific to certain investment categories. For example, bond investors face default risk—the risk that the issuer will fail to make interest payments or repay the bond’s par value at maturity.
2. Risk is usually linked with expected return
This is possibly the most important thing to understand about risk. Risk and return generally go hand-in-hand: If you put money into a low-risk investment, you should probably expect lower returns. If you choose a higher-risk investment, you’re seeking higher potential returns.
Of course, things don’t always work out the way you expect. A high-risk investment may not get better returns. (In fact, you could lose your entire investment.)
3. You should determine your risk tolerance
Your risk tolerance is how much risk you can comfortably live with in your portfolio. Determining your risk tolerance can be challenging. One indicator that you’ve exceeded your investment risk tolerance: when your investments’ performance keeps you awake at night—especially when there’s market volatility.
It’s OK to have a relatively low risk tolerance. However, focusing on lower-risk strategies may mean that you need to adjust your objectives (for example, having $750,000 at retirement instead of $1 million). Or, you may need to increase the time until you tap into your investments. For example, you may decide to work until age 68 instead of 65 so you have more time to earn money, add to your portfolio, and wait before you begin to withdraw funds.
4. Help is available
Because risk is complicated—and only one aspect of investing—look to your financial advisor for help with building your portfolio. Your financial advisor will take the time to get to know you, including your risk tolerance, before recommending an investment plan.