Do you like to play it safe? When it comes to managing your money, there may be no such thing.
Whether you invest in something as exotic as small-cap-emerging-market stocks or as plain vanilla as a bank savings account, your money is subject to some form of risk. You can't avoid investment risk, but you can manage it.
To begin to manage risk in your portfolio, you first need to understand the different forms of risk so you can decide which type of risk is more acceptable to take.
4 types of investment risk
There are four different types of investment risk to which your investments may be exposed:
- Price-volatility risk
The prices of freely traded securities go up or down every business day. Normal price fluctuations shouldn't affect anyone very much, but more extreme or sustained price declines can cause problems.
For example, the S&P 500, a measure of large-cap U.S. stock performance, has had a negative year in roughly one out of every three years historically. Calendar-year losses have been as steep as 47 percent. Obviously, if you had a need for your money at the end of a year that turned out to be one of those down years for the stock market, it could cause you to come up short.
How sensitive you are to price volatility is largely a function of your time frame. The longer you can wait before you need to access your money, the greater the likelihood that you can ride out normal fluctuations in market prices. If, on the other hand, you expect you'll need to access a significant amount of your money within the next one to three years, it is best to shy away from more volatile investments like stocks.
>> Worried about the stock market cycle? Read: Your strategy if the bull market is over
- Risk of permanent loss of principal
While you may be able to wait out normal fluctuations in price, some losses are permanent such as when a company you have stock in goes bankrupt or an issuer defaults on a bond you own.
Obviously, avoiding stocks and all but the highest-quality bonds is one way to reduce this risk -- but that also would cut down on your opportunities to seek better returns. Another approach that can help a great deal is to diversify. If you own a wide variety of securities and limit each one to a small percentage of your portfolio, you can reduce the impact of even a permanent loss in any one holding.
Key Insight: It is not enough to simply hold several different securities. It is also important to make sure you don't hold too many securities that are exposed to the same economic risks. For example, when the dot-com bubble burst, it took out a wide swath of the stocks in that sector, not just specific, isolated companies.
>> Learn more: How to profit from a stock market crash
Talking about price fluctuations and permanent loss of principal may make some investors feel inclined to retreat to the safety of low-risk investments like savings accounts or U.S. government bonds. However, while you can protect yourself from losses with guaranteed investments, you cannot protect yourself from earning sub-par returns if interest rates drop.
For example, a five-year U.S. Treasury security may seem about as safe an investment as you could choose. Price volatility is fairly limited and the principal is guaranteed upon maturity. However, their interest rates are subject to change over time and that can greatly affect your rate of return.
At the end of 1980, five-year Treasury yields were around 13 percent. Ten years later, though, this yield was down below 8 percent. By the end of the year 2000, it was around 5 percent. If you had made long-term investment plans based on 1980-style yields, you would have been disappointed to find your returns come up well short of that standard because of the need to reinvest your high-yielding Treasuries at progressively lower yields over time.
>> Stay on top of interest-rate trends: 2019 Outlook - 6 factors affecting savings and money market rates
Risk of inflation
Besides being subject to interest-rate risk, some of the seemingly safest investments may be very vulnerable to inflation risk. Take savings accounts, for example. It might seem there is nothing safer than an FDIC-insured savings account, but consider it from an inflation-adjusted point of view.
According to the latest MoneyRates.com America's Best Rates survey, the average savings account rate is 0.419 percent. Meanwhile, the annual inflation rate is running at 1.5 percent.
This means the average savings account is actually losing value, as measured by purchasing power, at a rate of over 1 percent a year. Only bank customers who find the highest-yielding savings accounts, which are now paying better than 2 percent a year in interest, are able to keep those savings ahead of inflation, and only then by a slim margin.
>> What inflation is doing to your CD rates
The need to stay ahead of inflation over time is a powerful reason why investors turn to growth investments like stocks, even though this means accepting frequent price fluctuations and the risk of permanent losses.
As you can see from the above examples, managing financial risk is largely about making a trade-off: avoiding one form of risk generally means incurring another form. The best you can do is keep your risks somewhat balanced and decide which types of risk are more acceptable to you than others.
More resources for beginning investors:
>> Ready to invest? Compare brokerages here: Best online brokers
>> Shopping for the best savings account rates? Read Best Savings Accounts of 2019
More resources for established investors:
To learn about portfolio re-balancing techniques for different age groups, read: Why you need to re-balance your investments today
Know your CD's inflation-adjusted value at maturity. Try our CD inflation calculator