Life can be risky. Buying a home, going back to school, changing careers, they’re all risky but may pay off for you in the long run. Investing is no different. Risk might sound scary, but can be an important element of investing—and may be the reason why your money grows over time.
Why investment risk matters
For an investor like you, risk refers to the degree of uncertainty and/or potential financial loss inherent in an investment decision. In other words, investing your money without knowing if you’ll receive the desired returns or experience unexpected losses.
So why risk it instead of stashing your money away? Risk may help you earn a greater return.
If you want to give your money a greater chance to grow, getting comfortable with risk may be a good idea. However, the level of risk you take on is up to you.
If short-term changes in the value of your investments don’t bother you, you’re probably fine taking on some amount of risk. However, if the thought of a drop in value—even for one day—gives you the chills, then taking less risk might be more your speed.
If you’re investing for long-term goals, it’s difficult to eliminate risk while earning a potential return on your investments.
There are two ways investment risk could benefit you
- Generally speaking, stocks can be a good way to help you earn investment return over the long term. Some years market indexes, such as the S&P 500 have been better than average and some worse, but when looking at longer periods, there have been fewer negative periods than positive. For the investors who took the risk and kept their money in the stock market over the long term, the value of their investments likely increased.1
- Inflation causes prices to increase over time. If you want your investments to keep pace with those increases, you may need to take on some risk.
But you’ll have to find balance—a spot where you’re earning enough return to help meet you retirement goals and be comfortable with the amount of risk you’re taking. Understanding how risk works and how you feel about it will help you find that balance.
Risks you face as an investor
Inflation risk
The tendency for prices to increase over time. It’s why a gallon of milk costs more today than it did 20 years ago, and why a dollar in the future may not buy as much as it does today. If inflation didn’t exist, you could put all your savings in a box under your bed until you need it.
Longevity risk
The risk of outliving your savings. Without knowing how long you’ll live, it’s tough to know how much money you’ll need in retirement. This risk is something you need to consider when making your long-term plan.
Some market risks you face as an investor
Market risk
The risk of loss due to changes in market factors that affect the overall performance of financial markets. Stocks can go up one day and down the next. The fact that these changes could result in a loss of value is what makes markets risky.
It’s important to note the difference between market volatility and market risk. Volatility is how frequently and significantly an investment changes price over time, while market risk is the probability that a change will result in permanent or long-lasting loss of value.
Interest rate risk
Fixed income securities, like bonds, are sensitive to interest rate risks when there are unexpected interest rate changes. As interest rates increase, the value of bonds typically decreases.
Credit risk
If the company issuing a bond experiences financial difficulty or fails, bondholders may not be paid the promised interest or the full amount of their principal.
Each of these risks can affect your investments and should be considered when making your investment choices. But just because they exist, doesn’t mean you can’t manage them.
3 strategies for managing risk
Before you can manage risk, you need to figure out how much risk is right for you. In addition, you should consider how well you manage your emotions and portfolio when the markets change.
Know your risk tolerance
Knowing your appetite to risk will place you on a scale somewhere between conservative (more averse to risk) and aggressive (more tolerant of risk). Your profile can help you select investments and build a portfolio at a level of risk you’re comfortable with, while continuing to work towards your goals.
As your investment goal gets closer, you have less time to recover from short-term market drops. Preserving the value of your investments becomes more important than seeking returns, so your risk profile will probably get more conservative over time since you have less time to invest and recover from downturns.
Don’t buy high and sell low
One of the most efficient risk-management strategies is simply sticking to your plan. By choosing to stay put, you’re giving yourself time to ride out period of volatility. When investing for a long-term goal like retirement, the earlier you invest the more risk you may be comfortable with—time helps you recover from market downturns and allows you to take advantage of potential market growth. If you aren’t very comfortable with risk, starting to invest early can also give you time to grow your account with less risky investments.
Diversify, diversify, diversify
Your last strategy in managing risk is diversification. Diversification is an important concept to remember when you’re building a portfolio. By spreading your money between different investments, you’re balancing the volatility of riskier options with the consistency of less risky investments.
Investing can involve risk—but that shouldn’t scare you. In fact, once you understand risk tolerance and the strategies available to manage risk, you’ll be able to build an investment strategy that helps you feel confident.
1 Based on calculations up to 2018, Standard & Poor’s
Investing involves risk, including possible loss of principal. Past performance does not guarantee future results.
Asset allocation and diversification do not ensure a profit or protect against loss.
Investing in equities involves more risk than other securities and may have the potential for higher returns and greater losses. The two main risks related to fixed-income investing are interest rate risk and credit risk. Please note, as interest rates rise, existing bond prices fall and can cause the value of an investment to decline. Changes in interest rates have a greater effect on bonds with longer maturities than on those with shorter maturities.
The subject matter in this communication is educational and is provided with the understanding that Principal® is not rendering legal, accounting, or tax advice. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, or accounting obligations and requirements.