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Investment Risk
Investment risk is the potential for your investment to lose its buying power.
No investment is complete free of risk. Every investment has risk.
You can bury your money in the ground. But, there is a risk it will be stolen. There is also an investment risk that, because of inflation, your money will lose some buying power when you dig it out.
A pound of butter, once called the "70 cent spread", is now over $2 a pound. And, have you checked the price of gasoline today? A stash of $100 buried 25 years ago might have bought 130 pounds of butter and 300 gallons of gasoline. Today it would buy only about 40 pounds of butter and 40 gallons of gasoline. The buying power of money has drastically declined.
This simply means that to help maintain and increase the buying power of your money you'll need to invest you money in ways that make more money.
You can invest your money in a bank savings or a money market account. You also risk losing buying power because the interest rates will probably be near or lower than the inflation rate. (The current inflation rate is around 4%.) And you will need to pay taxes on the earned interest, which reduces your gain even farther.
You can invest in a company's stock. There are risks that the profitability of the company and its stock will decline. Or, that the stock market in general declines and the short term value of your stock also declines.
You can invest in corporate or municipal bonds. But companies and municipalities have defaulted on their bonds in the past. Some bonds are called "junk bonds" just because of the uncertain financial future of the issuers of the bonds.
Bond values also decline when interest rates are increasing as they are now.
Every investment involves some degree of risk. But, every investment also involves the opportunity to increase the buying power of your investments.
An investment in your local bank may produce a guaranteed rate of return of 3% a year. But, an investment in a gold mining stock may produce a 100% increase in a single year. Would you be more comfortable investing at the bank, knowing the your low rate return is practically guaranteed? Or would you be happier investing in a gold mine knowing that there was an almost equal chance of gaining 100% on your investment or losing 40% of your investment?
The amount of risk and opportunity you are comfortable with is probably not the same as that of your neighbor or friend. Your spouse may also not be comfortable with choices you favor.
Nobody knows for certain what the future will bring. But, you can reduce your potential for loss by keeping a few strategies in mind.
- Invest for the long term. The value of any investment may go up or down in any month, or year. But, the long term trend of the overall market is up. The longer you intend to invest without taking money out of your portfolio the better your chances of getting a positive return.
- Diversify. You know the saying, "Don't put all your eggs in one basket." The same is true for investing. Lack of diversification will cause you to lose sleep at night with worry about your single investment.
Don't invest in a single high potential, high risk, stock or mutual fund. Spread the risk around. Put some of your money in a stable money market bank account or mutual fund. Then invest in a high quality "blue chip" mutual fund. Select a foreign or global fund, a "small cap" growth fund, and a variety of other types of funds.
The more broadly your investments cover all types of market sectors, the more likely a decline in one sector will be offset by an increase in another sector. If you invest in mutual funds, you should probably target 8 to 10 funds in a variety of categories. Invest first in one fund, then the next, until you have money in all your targeted funds.
- Dollar cost averaging. This simply means that you should consistently add to your investment portfolio over a lengthy period of time. It may seem like a good idea to add money to your investments only when the market has declined so you can ride the prices up. But, nobody has successfully timed the bottoms and tops of the market over any lengthy time period. Consistent investing will produce the best results.
- Periodic investment adjustments. Every 6 or 12 months take a look at how your investments are performing. You can take one or two of your worst performing investments and move the money in those investments to funds that are performing better.
These simple principles can help moderate your investment risk while still providing good returns. Learn the level of investment risk you will be happy with so you can sleep peacefully at night. Additional Resources
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