Investments in financial instruments represent a greater proportion of our generation’s household wealth than our parents’. Consequently, financial market volatility can have a significant impact on our family’s net worth, whereas in the past it may not have. So, it’s more important than ever that we understand the different types of investment risk to be able to better manage it. Here are the six key sources of risk in an investment portfolio:
Market risk is a concern that the rates of return for an entire asset class (e.g., stocks) will expose you to losses and result in less than expected returns over a period. Factor in market risk when evaluating your investment mix and keep the following in mind:
- Your time horizon, liquidity needs, investment goals, and risk tolerance significantly affect the amount of market risk you as an investor may want to tolerate.
- Large swings in the market usually don’t last for long periods.
- Eventually, the market should swing the other way, decreasing the range of long-term average returns.
- The longer you hold your investment, the less likely you have to worry about losses in any given year.
Industry Risk and Business Risk
Two other sources of risk are industry risk and business risk. Industry risk is associated with investing in a specific industry such as technology, energy, etc., while business risk is the risk that a stock or bond may decrease in value to a greater degree than the industry or market and may never recover. Because it can be very difficult to know which industries and companies will outperform, you can reduce these types of risk by diversifying and balancing your investments among many different industries and companies.
Your time horizon, liquidity needs, investment goals, and risk tolerance significantly affect the amount of market risk you as an investor may want to tolerate.
Inflation risk is the danger that the buying power of your money will decrease if the return on your investment (after income taxes and management fees) is lower than the inflation rate. To manage inflation risk, keep in mind that investing in a diversified portfolio of stocks has historically produced returns above inflation over longer periods. In addition, certain fixed-income securities issued by the U.S. government, such as “TIPS” (Treasury Inflation Protected Securities) and I-Bonds, also help provide inflation protection.
Interest-rate risk pertains to the change in the value of fixed-income investments, such as bonds or bond funds, as interest rates fluctuate. When interest rates rise, bond prices typically fall. Conversely, bond prices increase as rates decline. Rising interest rates depress the value of existing bonds because investors can buy new bonds paying higher prevailing yields.
On the other hand, if rates fall, potential buyers will be willing to pay a premium for an older, higher-yielding bond. Either scenario will affect the current value of your fixed-income investments. To manage this type of risk, you may want to consider a diversified portfolio that holds fixed-income securities of various maturities while considering that bonds with shorter maturities are subject to less interest rate risk than bonds with longer maturities.
Credit risk is the risk that the issuer of your bonds will default (not pay) on its loan to bondholders. To help manage credit risk you should check the financial stability of the issuer before you invest. Investors should manage credit risk by diversifying the investment among multiple credits and investing in low-rated credits to the extent the risk of doing so is tolerable. Again, these are important issues to discuss with your financial professional.
While it is impossible to eliminate all risk, speaking with a financial professional can help you better understand your own tolerance for risk and identify ways to help mitigate these and other risks in your portfolio.