Investment Fundamentals: Understanding Investment Risk

By Mitchell J. Smilowitz, CPA

The relationship between risk and return is among the most important investment concepts to understand. This article describes different types of risk, the relationship between risk and return and how you can manage risk within your investment portfolio.

First let’s look at the different types of investment risk.

Market Risk

Market risk refers to the possibility that an investment loses value when there is a general decline in financial markets. Both the stock market and bond market are susceptible to market risk.

Volatility Risk

Investments prone to large gyrations in price, such as stocks, are considered riskier. However, the short-term fluctuations in stock prices are offset by their potentially higher long-term returns. The risk is that you may need to sell the investment at a loss when the price is down.

Inflation Risk

Inflation risk refers to the potential that price increases will reduce your ability to purchase goods and services. At the 3% historical rate of inflation, what costs $50,000 today will cost about $100,000 in 25 years.

Credit Risk

Credit risk refers to the potential that a bond issuer will default on its obligation to pay interest or repay the principal on a bond.

Interest Rate Risk

Interest rate risk refers to the impact of changes in interest rates on bond investments. There is an inverse relationship between bond values and interest rates. When interest rates rise, existing bonds generally lose value. Conversely, when interest rates decline, existing bonds generally increase in value.

International Investment Risk

International investing involves additional risks. Political and economic instability can adversely affect investments in global companies. Currency risk caused by fluctuating rates of exchange between the dollar and foreign currencies can also affect the value of your investments. Differing accounting standards can make it difficult to accurately assess the value of a foreign investment.

Tools for Managing Risk

As a general rule, investments that carry higher rates of return also carry higher risk. Investors are often willing to accept more risk with the potential to receive higher returns. The objective is to get the highest returns possible without taking on a level of risk or type of risk that makes you feel uncomfortable.

There are three major tools for managing risk:  time, diversification and dollar-cost averaging.

Time is your most valuable ally in managing risk. The longer you can wait before you need to withdraw money from your portfolio, the greater the potential that your investments will increase in value. Consider the experience of the stock market over the last 93 years (1926-2018). Investors lost money in 25 of these years. Over the same time period, averaging investment returns over 15-year periods, we find that none resulted in losses. Time, in other words, can mitigate the risk inherent in investing.

Diversification offers another important tool for managing risk. There are two types of diversification. First, diversification involves holding a range of assets. These include:

The second approach to diversification involves holding more than one investment within each asset class. By investing in mutual funds, such as those the JRB offers, you are automatically investing in many different companies or bond offerings.

View the JRB’s Investment Offerings on the Risk Spectrum

Dollar-cost averaging allows you to reduce risk by investing at regular intervals and in roughly equal amounts. This strategy allows you to avoid the risk of investing a large amount at one time only to see the investment decline in value shortly after you make it. If you are contributing to your JRB account through a salary reduction program, you are already enjoying the benefits of dollar-cost averaging. If you have plans to rollover funds from another account into your JRB retirement account, speak with us about setting up a dollar-cost averaging schedule for these investments.

When you invest, regardless of the type of investment, you always accept a certain amount of risk. The JRB stands ready to assist you in establishing a balance between the risk with which you feel comfortable and the returns you need to meet your financial goals. Call us at 888-JRB-FREE (572-3733) or email us to set up a consultation.