All investments are inherently risky. Stocks, bonds, ETFs, and mutual funds can all lose value during a market downturn. Even an insured, conservative investment such as a bank-issued CD comes with the risk of inflation, and they might not earn enough over the years to keep up with cost-of-living increases. Below are several important concepts to understand when it comes to investment risk.
Risk vs. Reward
An asset class’ risk level is directly related to its potential return. The reasoning behind this is that an investor who’s willing to take a significant risk should be rewarded. In the investment context, a reward is the potential for a higher return. Typically, stocks have the highest return, followed by Treasury bonds, corporate bonds, and Treasury bills. All these investment types involve risk, which can vary depending on market conditions and the manner of use.
Volatility and Averages
Although historic averages often guide investors’ decision-making processes, it is difficult to know whether the averages will work in their favor. Even if an investor follows the advice of Kirk Chewning and diversifies their portfolio, there’s no guarantee that those investments will earn a return rate equal to or higher than the historical average.
By including multiple asset classes in a portfolio, an investor increases the chances that some of those investments will offer good returns even if others lose value. Put simply, the investor reduces the risk that comes with over-emphasis on one asset class, no matter how resilient that class may be.
When an investor diversifies, they divide funds allocated to an asset class among the categories in the class. Diversification emphasizes variety, allows the investor to spread their spending around, and keeps them from putting all their eggs in a single basket.
Insurance and hedging (buying securities to offset losses on other investments) can help investors mitigate risk. However, these strategies often increase the cost of the investment, which erodes returns. Furthermore, hedging involves high-risk activities like short selling or investment in non-liquid securities.
As said before, every investment carries a degree of risk. By understanding the nature of these risks and taking action to manage them, investors put themselves in a position that allows them to meet their short- and long-term financial goals.