Understanding Risk and Diversification
As you evaluate what kind of investor you are and how much risk you can take on, remember that risk is the chance that the value of your investment will decline.
A key to managing risk is to spread your investable dollars over a variety of investment types. Because different kinds of investments have performed better at different times, diversification can help offset the volatility of a single asset or asset class by taking advantage of the respective strengths of each asset class. To seek diversification, most experts recommend including several asset classes (equities, fixed income, cash, etc.) in your long-term portfolio.
There are several different types of risk that may affect your investment:
- Market risk is the possibility of losing money because of a decline in market value.
- Inflation risk is the danger that your money will not grow as fast as the rate of inflation, so it 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.
- Interest-rate risk comes from the relationship between securities and interest rates. Fixed-income investments tend to drop in price as current interest rates rise and gain value when interest rates decline.
- 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. With market timing, you have to guess right twice - when you buy and when you sell. Being wrong about either a dramatic rise or a sudden fall in prices can mean a significant loss to you.
- 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.