All investments carry risk. But, as an investor, one of the biggest risks you face is that of not achieving your long-term goals, such as enjoying a comfortable retirement and remaining financially independent throughout your life. To help reach your objectives, you need to own a variety of investment vehicles — and each carries its own type of risk.
If you spread your investment dollars among vehicles that carry different types of risk, you may increase your chances of owning some investments that do well, even if, at the same time, you own others that aren’t. As a result, you may be able to reduce the overall level of volatility in your portfolio. (Keep in mind, though, that diversification can’t guarantee a profit or protect against all losses.)
To diversify your risk factors, you first need to recognize them. Here are some of the most common types of investment risk:
Market risk — This is the type of risk that everyone thinks about — the risk that you could lose principal if the value of your investment drops and does not recover before you sell it. All investments are subject to market risk. You can help lessen this risk by owning a wide variety of investments from different industries and even different countries.
Inflation (purchasing power) risk — If you own a fixed-rate investment, such as a Certificate of Deposit (CD), that pays an interest rate below the current rate of inflation, you are incurring purchasing power risk. Fixed-income investments can help provide reliable income streams, but you also need to consider investments with growth potential to help work toward your long-term goals.
Interest-rate risk — Bonds and other fixed-income investments are subject to interest-rate risk. If you own a bond that pays 4% interest, and newly issued bonds pay 5%, it would be difficult to sell your bond for full price. So if you wanted to sell it prior to maturity, you might have to offer it at a discount to the original price. However, if you hold your bonds to maturity, you can expect to receive return of your principal provided the bond does not default.
Default risk — Bonds, along with some more complex investments, such as options, are subject to default risk. If a company issues a bond that you’ve bought and that company runs into severe financial difficulties, or even goes bankrupt, it may default on its bonds, leaving you holding the bag. You can help protect against this risk by sticking with “investment-grade” bonds — those that receive high ratings from independent rating agencies such as Standard & Poor’s or Moody’s.
Liquidity risk — Some investments, like real estate, are harder to sell than others. Thus, real estate is considered more “illiquid” than many common investments.
Make sure you understand what type of risk is associated with every investment you own. And try to avoid “overloading” your portfolio with too many investments with the same type of risks. Doing so will not result in a totally smooth journey through the investment world — but it may help eliminate some of the “bumps” along the way.