Understanding Risk and Diversification
There is no opportunity without risk. When you invest, you have to be prepared for risk. There is simply no avoiding it. But there is a way to minimize risks to a level you can tolerate. That’s important for both your financial and emotional health.
What Is the Right Level of Risk for You?
First, let’s define risk. Risk is the price you pay to pursue opportunity. In the investment world, risk is the chance that the value of your investment will decline: taking less risk will generally result in lower returns whereas assuming higher levels of risk should generate higher potential returns.
The important thing is to understand how much you can stand to lose — because, while there are strategies to limit risk through your investment choices, you can't eliminate it completely. Your investment portfolio should be crafted to provide the right balance of risk and return opportunities so that you can achieve your goals and be able to sleep at night.
Your risk tolerance is different from everyone else’s. How you decide to invest in order to minimize risk to a level where you are comfortable will be influenced by your personality, financial situation and your stage in life.
What is your personality?
Are you naturally cautious or do you have to fortitude to weather the ups and downs in the markets?
What are your finances like?
Do you have enough assets to provide a safety net in the event of a down market? Or do you rely on your investments to meet current needs, such as generating a cash flow?
Where are you in your life?
Are you young, with many years ahead of you to recoup potential losses, or do you intend to tap your assets in the near future and need to protect the value of your nest egg?
Diversification: A Proven Strategy to Help Manage Risk
A key to managing risk is to spread your investable dollars over a variety of investment types — because different kinds of investments perform better at different times. While this strategy cannot guarantee against a loss, it is one of the best ways to help you reach your goals and minimize risk.
To seek diversification, most experts recommend that you spread your investments among many different asset classes —cash, stocks, bonds, mutual funds, real estate, or perhaps alternative investments — as well as industry, style and country. By picking investments with diverse characteristics, you can help ensure that if one drops in value it will be balanced out by others that are performing well.
How many investments do you need to be adequately diversified? Opinion varies greatly. Early studies generally found between 10-20 stocks was optimal, however more recent studies indicate that increased market volatility has led to a greater need for diversification: the number of stocks can range from 55 to more than 110 in times of market distress.*
For the average investor, managing a portfolio of over 100 stocks is beyond their reach — either because of the lack of time, experience or resources. Further, while it's important to diversify broadly, it’s important to know what you own so you can avoid a lot of overlap. Many investors turn to mutual fund portfolios that are researched and actively managed by professionals to achieve diversification, but be careful you don’t invest in similar funds holding the same types of stocks — diversification at the fund level still holds true.
Understanding different types of risk
Below we briefly outline some of the most common investment risks. However, one of the least considered types of risk is behavioral risk — the personal emotions that rise and fall with the ups and downs of the market. Behavior risk is usually greatest in down markets as investors watch the value of their investments fall. It is important to understand what level of risk you can tolerate and how much you can afford to loose — and invest accordingly. Otherwise, you might be inclined to sell when a stock is falling and lock in a loss.
- Market risk the most commonly understood risk — is the possibility of losing money because of a decline in market value. Because market fluctuations are how investors realize gains, volatility is essential for returns. The more volatile an investment the more dramatic price changes will be — both up and down.
- Inflation risk is the danger that your money will not grow as fast as the rate of inflation, which means a dollar will not be worth as much tomorrow as it is today. Inflation risk may well be the most important concern for the long-term investor.
- Credit risk is the risk that a company will default on its debt obligations. Government bonds are typically considered the safest and offer the lowest returns. Corporate bonds come in a range of risks, from investment grade to junk bonds.
- Interest-rate risk results from the relationship between securities and interest rates. Bond investments tend to drop in price as interest rates rise and gain value when interest rates decline.
- Foreign investment risk includes exposure to political events, currency exchange rate changes, and other conditions that affect the value of investments traded or located in foreign countries.
- Market-timing risk is when you try to beat the market by buying investments when prices are at their lowest and selling at their peak. Being wrong about either a dramatic rise or a sudden fall in prices can mean a significant loss to you.
Investors should consider the investment objectives, risks, charges, and expenses of a mutual fund carefully before investing. Download a prospectus, or summary prospectus, if available, that contains this and other information about the fund, and read it carefully before investing.