| Understanding and Managing Risks |
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Most people aren't worried about earning too much on their investments; rather, they are concerned about the possibility of losing their hard-earned money. Mutual funds, managed accounts, and other securities do offer us potentially higher returns than guaranteed savings accounts, but in exchange for this they also come with certain risks.
When investing in mutual funds and managed accounts, the main risk you face is the uncertainty of future rates of return, which can result in the erosion of your investment. Here's a breakdown of risks, which can be experienced in any combination:
- Market Risk—the risk that movement in the financial markets will adversely affect your investment. You can always be assured of one thing when investing—the markets will fluctuate based on many factors, such as the state of the economy, current events, corporate earnings, interest rate movements, and sometimes even a statement from a high-ranking federal official!
- Interest Rate Risk—the risk that the value of a fixed-income investment will drop as interest rates rise. Bond prices are inversely related to interest rates, that is, if one goes up, the other goes down. If you're heavily invested in bonds, the value of your portfolio may be greatly influenced by interest rate fluctuations.
- Inflation Risk—the risk that the return on your investments will not keep pace with rising consumer prices. Historically, fixed-rate securities have sometimes not returned enough to protect investors against inflation, while, over the long term, equity securities have tended to keep up with or exceed it.
- Business Risk—the risk that a company issuing a security may not be financially healthy due to any number of factors, like poor management, low product demand, or exorbitant operating expenses. Such situations can result in a plunge in the security's value, as well as a dividend reduction or elimination.
- Credit Risk—the risk that a bond issuer will not be able to repay its debt at maturity. Bond ratings by agencies like Moody's and Standard & Poor's identify the quality and risk level of bonds. Highly-rated bonds tend to carry the lowest risk, while bonds with low ratings, like high-yielding junk bonds, are typically the riskiest.
- Currency Risk—the risk that fluctuations in the exchange rate between the U.S. dollar and a foreign currency may decrease the value of a security that is either invested in or whose value is derived upon that currency. Global and international investments are most subject to this type of risk.
- Political Risk—the risk that political and/or governmental actions or events may unfavorably influence the value of a security.
- Liquidity Risk—the risk that underlying securities cannot be sold at a fair price within a reasonable period of time. Shares in large blue-chip stocks are considered liquid because there are a large number of outstanding shares that are actively traded. As a result, their stock prices are not dramatically affected by day-to-day buying and selling. Conversely, small-company stocks with less outstanding shares are generally not considered liquid, since a few big buy or sell orders can greatly influence the share price.
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What You Can Do to Help Manage Risk
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Here are some time-tested ways to help you manage risk in your portfolio:
- Educate Yourself—Be familiar with the types of risk you are exposed to within your portfolio. If you are not willing to accept much risk, you should probably think twice before investing in funds that are exposed to more types of risk than others. For example, international and global stock funds are subject to the majority of risks mentioned in the previous section, while domestic stock funds are less likely to experience political and currency risks.
- Spread Out Risk—Diversification is key in helping to temper some types of portfolio risk. The process of diversifying, known as asset allocation, can help to minimize some risk by spreading your money among several different asset classes. Therefore, when one asset class is adversely affected by market or other conditions, another class may be less affected or not affected at all. Diversification does not assure a profit or protect against market loss.
- Keep Your Goals in Mind—The shorter your investment time horizon, the more your portfolio could be adversely affected by market volatility. If you don't have a lot of time to invest for a goal, consider your tolerance and financial ability to ride out market ups and downs. You may decide to invest in a more conservative fixed-income or money market fund instead of a stock fund.
- Don't Forget About Future Costs—While long-term investors are better suited to tolerate market fluctuations, inflation risk should still be a consideration. If you are investing for a long-term goal like retirement, you probably have a larger percentage of stock funds in your portfolio. Over the long term, stocks have historically kept pace with or exceeded inflation.
- Consider Your Income Needs—Perhaps you are already retired and living on a fixed income. You most likely want your investment portfolio to include income-producing investments, such as high-quality bonds and cash investments. You may also be comfortable having some equity securities in your portfolio to keep the potential for growth.
- Tap a Valuable Resource—Consult your investment professional for guidance in understanding and managing risks. He or she can provide you with detailed fund and performance information to help you match your investments to your goals.
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