(Prosperity)
Define: Risk
Some people like to sky dive – enjoying their 4000 meter rush to the earth at approximately 120 mph. Some people live life to the fullest by driving 5 miles faster than the speed limit. Your level of risk tolerance is a highly personal indicator.
In investing, risk is the possibility that investment results may be less advantageous than expected. ‘Risk’ is a measure of your willingness to see securities decrease in value while waiting, and hoping, for an eventual increase.
Virtually, every investment has risk associated with it, but at different levels. The level of risk in an investment typically corresponds to the return potential (yep, we’re back to that whole no guts, no glory theory of investing.) If you leave your money under the mattress, you won’t lose any, but you will lose out on any growth potential. Check out What To Know By Age and the definition of Compound for more on this. All investments are trade offs of risk and rewards.
In investing, risk is also a measure of the time you have to let your investments ride. If you have more time for your investment to succeed, you may want to look for a higher risk/higher return than someone who needs the money immediately. Buying when prices appear to be low, and trying to turn around a sell when prices are higher is called "timing the market" and it's one of the hardest things to do (right up there with statistics and some of the more complex yoga moves). Long term investing gives you time to ride out any market corrections, dips and even recessions.
A diverse portfolio, where assets are allocated across securities, can spread out your investment risk. Different assets and securities usually react differently to market conditions. A diverse portfolio reduces your vulnerabilty to varying market conditions.
For instance, some of the risks involved with mutual funds include:
Equity Risk: Stocks in a fund may decline in value for extended periods due to the activities and prospects of individual companies, or due to general market and economic conditions.
Company Size Risk: Small and mid-size companies’ stocks involve greater risk than the securities of larger, more-established companies. Small to mid-size companies often have limited product lines, markets or financial resources and their securities thus may be more sensitive to market volatility or changes business conditions in a particular line of commerce.
Global Investing: Besides ordinary market risks, foreign securities present certain unique risks, such as currency fluctuation, political and economic changes. All of these factors may result in greater volatility.
With bonds, the biggest risk is that the value of the bond will decrease with an increase of interest rate - market values of a bond fluctuates inversely with the interest rate. This is when you may be able to pick up bonds at a discount, verses holding a bond until maturity.
U.S. Government Bonds: When interest rates rise, the present value of bonds or the value of a bond fund declines – selling before maturity, but after an interest rate rise can cause the investor to lose on the principal value on the holding. While bonds are guaranteed by the government, this assurance applies only to the prompt payment of principal at maturity and interest when do. Government guarantees do not protect against market-driven fluctuations (ahem, decreases) in price or yield during the life of the bond.
Municipal bonds: Interest on obligations of state and local governments is usually free of federal income tax, but all or a portion of municipal bond interest income may be subject to taxes at the local and state levels, and even possibly qualify for the alternative minimum tax.
Corporate Bonds, Including Low Quality and Non-Rated Bonds (JUNK): These present the greatest risk for loss of principal and interest, because the issuers are exposed to general risks that affect any business enterprise including insolvency.
Some risk is involved with all investing, but (and you’ve seen us express this before) the reward can be worth the risk. If you’re still uncertain, go ahead and take a refresher course on the power of compounding. And if you’re looking for that killer adrenalin rush, we recommend skydiving over junk bonds and penny stocks.