Investing involves different types of risk; how you deal with those risks is an important part of your investment strategy. But first, you need to understand what these risks are. Here are five common types of investment risk, and some general strategies used to reduce them.
Market risk is the possibility of a loss in principal due to the negative changes in the market price of an investment. This is closely associated with the volatility of the stock market, though other investments are susceptible to market risk, too.
To reduce market risk, take a long-term approach to investing and only invest money that you don’t currently need. This way, you can afford to keep an investment during down periods in the market instead of selling it for a loss. Also diversify your investments across different types of assets: stocks, bonds, cash, etc., and in different sectors within each asset class. This will improve the odds of having some investments that are up in the market while others are down.
Inflation devalues the money you have over time. The purchasing power of $100 ten years ago was higher than it is today; most likely, the purchasing power of $100 today is higher now than it will be in ten years. If an investment offers low returns, it is vulnerable to inflation risk: the risk that the return of an investment won’t be higher than the rate of inflation.
To curb inflation risk, take on more market risk for investments with average returns higher than the average rate of inflation. Usually, this means investing in stocks, but there are bonds and other types of investment that have a history of higher returns.
When you purchase a bond, you assume credit risk (or default risk). This is the risk that the issuer of the bond might default on the debt. US Treasury bonds generally have very little credit risk but have very low returns as a result. Corporate bonds can be riskier but can offer better returns.
As with market risk, diversifying the bonds you buy can decrease your credit risk. Investing in companies that have high credit ratings can also lower your risk. Again, US government bonds tend to be very safe credit risks, though they do have greater inflation risk.
A liquid asset is an asset that can be easily converted to cash with little or no loss of value. Liquid risk is the possibility of just the opposite. For example, if an asset has too many sellers, it might take a while to find a buyer without losing value on the asset.
You can reduce liquid risk by investing in actively traded assets. Also, if you invest money that you don’t currently need, you can afford to hold onto it until you find the right opportunity.
Interest rate risk
Interest rate risk is the risk that investments will lose their value as interest rates rise. Generally, as interest rates rise, the value of investments (most notably bond prices) tends to fall and vice versa.
You can create a “bond ladder” which invests similar amounts of money in several bonds that mature at regular intervals over a long period of time. This can balance the ups and downs of interest rates over that period, lowering your interest rate risk.
Invest despite the risks
Although there are risks in investing, not investing can be risky, too. In fact, simply holding onto cash makes you susceptible to inflation. If you’re not investing already, consider starting with something like an IRA to prepare for retirement. Then you can move on to other investments to help you reach the rest of your financial goals.
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