When you invest, you take some risks. While you can’t totally avoid these risks, you can take steps to help reduce their impact and increase your comfort level. And the more comfortable you are with your investments, the easier it will be to follow a long-term strategy that can help you meet your goals.
Let’s look at the most common types of risk related to investing, along with some suggestions on helping to reduce these risks:
• Losing principal: This type of risk is most closely associated with investing. For example, when you purchase a stock, you know that its value could go up or down. If it drops below your purchase price and you then sell your shares, you will lose some of your principal.
• Your response: You can’t eliminate the risk of losing principal, but by owning a mix of stocks, bonds, government securities and other types of investments, you can help reduce the impact of volatility on your portfolio. Keep in mind, though, that diversification by itself can’t guarantee a profit or protect against loss.
• Losing value when interest rates change: This type of risk primarily affects fixed-income investments, such as bonds. If you purchase a bond that pays, say, a 4 percent interest rate and the market rate goes up to 5 percent, then the value of your bond will drop because no one will be willing to pay you the full price for it when newer, higher-yielding bonds are available.
• Your response: You can combat, or even ignore, interest-rate risk by holding your bonds until they mature. By doing so, you’ll get your full principal back, provided the issuer doesn’t default, and you’ll continue to receive regular interest payments unless the bonds are “called,” or repurchased by the issuer. You can help protect against this by purchasing bonds that have some degree of “call protection” and by owning bonds with different maturities.
• Losing purchasing power: This risk largely applies to fixed-rate investments such as certificates of deposit (CDs). To illustrate: If you purchase a CD that pays 2 percent and the inflation rate is 3 percent, you actually are losing purchasing power.
• Your response: Despite their vulnerability to inflation, CDs can offer you some valuable benefits, such as preservation of principal. Yet if you are concerned about fighting inflation, you may want to look for investments that have the potential to offer rising income, such as dividend-paying stocks. In fact, you can find stocks that have increased their dividends for many consecutive years. Be aware, though, that companies can reduce or eliminate dividends at any time. Also, an investment in stocks fluctuates, and you could lose your principal.
Apart from these individual techniques to reduce investment-related risk, you also should save early and often because the more money you accumulate, the greater your ability to follow a long-term strategy that reflects your personal risk tolerance. That’s why it’s a good idea to contribute as much as possible over the years to your IRA and 401(k) or other employer-sponsored retirement plan.
By understanding the different types of investment risk, and by acting to help lessen them, you can reduce much of the stress sometimes associated with investing while you increase your prospects for achieving your objectives.
Cardella is a financial advisor in Hinesville for Edward Jones, which provided this column.