If you’ve gone through basic training (or ever been to a gym), then you know that there is no gain without pain. Sure, doing more than 50 pushups in two minutes may be uncomfortable. But there’s a direct connection between fitness and readiness. And there’s an investment analogy here.
Investment return is compensation for taking risk. The whole point of investing is to build wealth so you can buy the things you want (i.e., achieve specific consumption goals). Building wealth comes with some risk. Understanding that risk may make it easier to manage.
Categories of Investment Risk
It’s important to understand what the term investment risk means. It’s an outcome other than you expected, like the possibility you’ll lose money on an investment.1
That’s a pretty common concern of most investors. So, let’s deal with that.
But please, wrap your head around this. The investment risk most people worry about is the easiest to explain.
Look, all investments (especially stocks and bonds) have risk. But when it comes to losing value there are only two causes…yes…just two.
Systematic risk is market risk.
This explains why your equity mutual fund may decline when the stock market is down. Systematic risk applies to both stocks and bonds.
What you own has nothing to do with systematic risk. It’s just the nature of markets.
Unsystematic risk is specific to an individual security. It’s the risk that on any given day for any or no obvious reason, the value of a particular stock or bond may be up or down, regardless of what the market is doing.
Risk Comes With the Territory
Stocks and bonds have different risks.
Stocks are more volatile than bonds. So, the main risk in stocks is a potential loss of capital, but typically only if you sell. That’s also true of bonds. Selling typically is what triggers losses.
Okay, sometimes a stock or bond won’t recover from a price decline. But that’s generally not the rule.
Now, bonds have other unique risks.
They can fall when interest rates rise. An individual bond’s price can decline if the underlying company’s credit rating falls.
There are other risks if you hold a bond to maturity.
Lower interest rates at maturity means you might not be able to replace your income. If inflation is higher than the rate your bond pays, you’ll have less purchasing power than you started off with.
What you can do About Investment Risk
Reducing systematic (market) risk and taming unsystematic (security specific) risk don’t have the same remedy.
Actually, there’s no cure for market risk…other than intestinal fortitude. Asset allocation may help you reduce portfolio risk, but the assets in it will still have systematic risk.
Luckily, diversification can help you decrease unsystematic risk. That just means owning more than just a few stocks or bonds. Mutual funds and ETFs may help you here.
Avoiding Investment Risks vs. Avoiding Investment Losses
Risk is not the same thing as loss. There are lots of reasons investments lose value. But price declines are typically short lived.
One important way to avoid losing money is to stay the course. That means do not sell something today that was a great investment yesterday. Don’t let market fluctuation scare you into realized losses.
Another is to work with an investment specialist who can help you tailor a portfolio appropriate for your specific circumstances, someone who can explain diversification and help you manage investment risks.
Call us now at (800) 235-8396 to have that conversation.
1 Most people say that investment risk is the chance of losing money. Source: Katharina Sachse, Helmut Jungermann, Julia M.Belting, Investment risk – The perspective of individual investors, Journal of Economic Psychology, Volume 33, Issue 3, June 2012, Pages 437-447.