Investments

It is important for investors to understand that every investment has its own set of risks. One key to successful investing is to recognize the different types of risks that could be a threat to one’s financial well-being and to take steps to minimize their impact. What follows is an overview of the primary forms of investment risk as well as some tips on how to minimize that risk.

Market Risk

This is the risk that the prices of securities may fall due to external factors such as world events, economic changes, or investors’ expectations and outlook. Stock investors are more likely to be impacted by this form of risk than fixed-income investors.

Inflation Risk

Also known as purchasing power risk, this is the risk that is connected to the uncertainty over the future purchasing power of the income and principal of an investment. When prices rise (inflation), purchasing power typically falls. Historically, stocks have been less impacted by this type of risk since they have been able to appreciate in price at a faster rate than the rate of inflation. Typically, lower yielding cash equivalents are more likely to be affected by a rise in inflation.

Interest Rate Risk

When interest rates move up and down, bond prices change. When interest rates move up, newly issued bonds will generally pay a higher interest rate than similar, older bonds. What happens next is that the market of existing bonds falls because there is less demand for them. In other words, they lose market value. The opposite happens when interest rates fall: Older, previously issued bonds will pay higher rates of interest than newly issued bonds, making the older bonds more appealing to investors. The bottom line is that falling interest rates are generally beneficial to bond owners.

Maturity Risk

Since it is impossible to predict how the financial markets will perform in the future, long-term bonds are generally considered to be riskier investments than short-term bonds. This type of risk is known as maturity risk. Issuers of long-term bonds attempt to compensate for the additional risk by offering higher yields.

Credit Risk

Credit risk is the risk that a bond issuer will be unable to pay interest on the bonds it issued or repay principal when the bonds mature. Rating services, such as Moody’s Investor Services and Standard & Poor’s, carefully investigate the financial health of a bond issuer in order to alert investors to the risks of a particular issue. The rating services rate municipal bonds, corporate bonds, and international bonds. They do not rate Treasury bonds since the assumption is that they are solid, backed by the full faith and credit of the federal government. The rating services rate bond quality according to a system that employs letters and numbers, with AAA or aaa indicating the highest quality issues and CCC or ccc and below indicating poor quality issues that could default.

Credit ratings influence the interest rate an issuer must pay in order to sell its bonds. However, credit ratings are opinions about credit risk. Even though credit ratings are forward looking in that they assess the impact of foreseeable future events and can be useful to investors, they are not a guarantee that an investment will pay out or that an issuer will not default.

Currency Risk

Changes in currency exchange rates will have an impact on returns from overseas investments. For example, when the dollar rises in value in relation to the Euro, the return on a fund that holds a large number of stocks in European businesses is reduced when the Euros are converted to U.S. dollars. The opposite occurs when the dollar falls in value in relation to the Euro.

All investments have risks. Before buying a security, understand that the key to investing success is balancing risk. You can do this by having a well-diversified portfolio and an asset allocation strategy based on your risk tolerance and the number of years until you retire.

Diversification helps you manage risk by spreading your assets among a broad mix of different investments. When you do this, you are taking advantage of the fact that securities usually don’t move in the same direction at the same time. When some investments drop in value, others may rise or remain unchanged, offsetting to some degree those investments that lose value. Of course, diversification does not ensure a profit or protect against loss in a declining market.

Be sure to talk to your financial professional for insights on how you can balance risk in your investment portfolio.

Stock market volatility can be a wild ride. If you follow the daily price movements of a stock market index, it’s enough to make you dizzy at times. If you watch the same index’s performance over longer periods, however, you may notice that things tend to smooth out.

Unless you’re close to retiring and will need to tap your assets soon, taking the long-term view probably makes sense. Rather than making investment decisions based on day-to-day or even quarter-to-quarter performance, step back and look at how your investments are doing over longer periods.

Stocks Over the Long Term

Of the three major investment types — stocks, bonds, and cash alternatives — stocks are attractive to long-term investors because they have 1 historically provided the best opportunity for growth and the highest relative return over the long term. However, stocks have more short-term volatility than the other two investment types, so they carry more risk.

Time Makes the Difference

It’s never good when prices drop and your stock investments lose value. It’s particularly bad news if you’re going to need your money soon. But when you have time on your side, you can focus on an investment’s long-term performance numbers (and the stock market’s overall long-term performance) instead of its day-to-day ups and downs.

Although past performance is no guarantee of future returns, and it has sometimes taken years, the stock market has always bounced back following periods of price drops. When you have time to wait, the stock investments you hold could rebound following any future market dips.

Your situation is unique, so be sure to consult a professional before taking action.