Maybe you prefer putting your money in a savings account or a certificate of deposit (CD) because it feels safe. Believe it or not, both of these strategies carry some degree of risk. There’s a chance your money may not be able to keep up with inflation. That means each dollar may be worth less in future years.
There is a risk that the price of a stock (typically those that pay dividends) or bond will fluctuate because of changes in interest rates. For example, if interest rates go up, bond prices typically go down. If rates go down, bond prices typically go up. Since stocks and bonds can react differently to the same events, diversifying your holdings by investing in both stocks and bonds can help reduce the volatility, or the swings, in your overall portfolio’s value.
Both stocks and bonds are vulnerable to changes in the economy and to general changes in the markets in which they trade. Although stocks and bonds issued by companies are tied to profits and losses of those companies, there are factors and cycles outside of the companies’ control that may cause a rise or fall in prices. The risk is commonly found with investments in stocks, but can affect bonds as well.
Think credit cards. When you borrow money, you have to make payments plus interest to pay off your debt. The same holds true for companies that issue bonds (or IOUs) to the public. There’s a chance that companies that issue bonds won’t be able to make interest payments or return all of your principal. That’s credit risk.
If you can’t sell or redeem an investment quickly at a fair price to get the cash, it’s an indication that your investment has low liquidity. A lack of liquidity can affect the price of stocks and bonds.
Many people define risk as the possibility that the value of their stocks and bonds will go down. Stocks and bonds can be volatile, especially in the short run. That’s why your time frame is perhaps the most critical component in planning your investments. For example, if you are investing for a retirement that is 25 or 30 years away, you have several years to recover from the possible ups and downs of the market. What if your time frame is shorter? If you’re close to retirement or if your child is headed to college in just a few years, you may not have the time to ride out a downturn. Your tolerance for risk in this case may be lower and you may want to consider investments that historically have been less volatile.
One big risk most investors face is that their purchasing power will be eroded by rising prices in the future. “Playing it safe” and accepting lower market volatility also means accepting the potential for lower returns — a risky strategy if you are trying to keep up with or even beat inflation. Even after you retire, you may want to keep some of your assets in growth-oriented investments — after all, you may be retired for 10 to 20 years or more.
This may be the most important question you ask. Being as specific as possible when answering will help you plan. Once you know your goal, work with your financial professional to match your investments to it. If your goal is ambitious, you may have to accept higher volatility and a greater chance of loss in return for the potential to reap higher rewards. But if your goal is modest, you may be willing to accept the trade-off of less gain for lower volatility.
What kind of investor are you? Are you less concerned by the peaks and valleys of investing? Or do you prefer as steady an investing experience as possible?
The reward for holding on to your investments through both up and down markets is that your investments may grow in value. But you have to be willing to hold on through the long term in hopes of reaching your goals. If you go the slower route with less volatile investments, your investments will probably fluctuate less, but may not reward you as much in the long run.
Most mutual funds are made up of a combination of stocks, bonds and cash equivalents. Where do they stack up with respect to risk and reward?
Stocks have the highest potential reward, but tend to be the most volatile.
Bonds can help provide a stream of income and are typically less volatile than stocks, but they tend to have less long-term growth potential.
Cash equivalent or money market instruments offer the most stability, but very little growth potential.
All mutual funds have different degrees of risk, so you can create a portfolio with investments that reflect your own risk tolerance to help you reach your investment goals. When you choose a mix of funds with different objectives and strategies, you are diversifying.
Diversification helps to reduce volatility risk by spreading your money among several investments. If one of them declines in value, the loss to your overall portfolio may be reduced because your other investments may not duplicate its results. It's important to note that during some market declines, a variety of investments may decline. In these cases, however, diversification can still soften the overall effects on your portfolio.
If you’re investing for the long term, you may want to consider growth funds, which contain mostly (if not exclusively) stocks. This strategy may help you reduce the risk that inflation will erode the value of your investments over time. As with all investments, it's important to maintain a long-term perspective.
If you need your money soon and opt to take on more risk, understand that there’s a chance that you could find yourself cashing in your investments when the market is down. The shorter your investment time horizon, the greater the risk of loss.
Talk to your financial professional before making any changes to your investment plan or if you want more information about risk.
Investments are not FDIC-insured, nor are they deposits of or guaranteed by a bank or any other entity, so they may lose value.
Investors should carefully consider investment objectives, risks, charges and expenses. This and other important information is contained in the fund prospectuses and summary prospectuses, which can be obtained from a financial professional and should be read carefully before investing.