Investment Risk and Reward Go Hand in Hand

For many people, the word risk connotes something negative. They prefer to stay away from risk as much as possible. Yet the flip side of risk is reward. When it comes to financial planning, risk is unavoidable. But it is also manageable, and can work to your benefit, if you have an understanding of the different types of investment risk and of your personal tolerance for risk.

Warren Buffet, the legendary investor, says, “Risk comes from not knowing what you’re doing.” So the more you are familiar with investment risks the easier it will be to manage your portfolio.

In general, risk is the degree to which an investment might fall short of the return you expected, or even go bust altogether. Every investment carries with it a potential reward and risk.

Types of Investment Risk

There are many types of risk that can affect an investment. Among the most common are the following:

• Capital risk: This is the risk that your original investment will decline in value and you won’t get back all, or perhaps any, of your money. Most people view capital risk as the most worrisome, especially in light of the losses investors experienced in the market crash of 2007-2008.
• Inflation risk: Inflation is the rate at which prices rise over time. The risk here is that increases in inflation will outpace the growth of your investments. When that happens, the buying power of your money is reduced. For example, a 2.5 percent inflation rate over 10 years reduces the value of $1,000 to $781. Allowing for inflation is one of the most critical elements of long-term retirement planning.
• Market risk: This is when an entire market index falls, such as the Dow Jones Industrial Average. While losses may vary among different types of investments, all asset classes share in the decline to some extent. Conversely, all asset classes gain in a rising market.
• Interest rate risk: Interest rates drive the amounts of income investors receive from bonds and other fixed income investments. When rates go up, the price of these investments decline. When rates fall, the price increases.
• Credit risk: The risk here is that the issuer of a bond or other security – say a corporation or financial services company – defaults on its obligation to repay principal and interest to investors. Bonds issued by the federal government are generally immune from default.

What’s Your Risk Tolerance?

The extent to which you are willing to assume investment risk is a highly personal matter. Risk tolerance varies widely from person to person. Since every investment involves some risk, it’s important for you to consider the possible consequences if things don’t work out as planned. If, in your view, the consequences are not acceptable, it’s probably better not to take the risk.

However, even the most conservative investor must assume some risks. The key is to find the right balance between risk and reward that works for you. If you understand the risks and how they impact your investments, you will be better prepared to manage them and achieve your long-term financial goals.

This information is written in connection with the promotion or marketing of the matter(s) addressed in this material. The information cannot be used or relied upon for the purpose of avoiding IRS penalties. These materials are not intended to provide tax, accounting or legal advice. As with all matters of a tax or legal nature, you should consult your own tax or legal counsel for advice.

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