Investment Risk: As in life, courage pays off
Risk can be managed but not eliminated
When investing money, the word “risk” is used as an expression of uncertainty. The level of uncertainty tolerated by anyone investing precious funds is specific to the individual.
Many investors look at risk as the probability you will lose the money that was invested. Say someone purchases 100 shares of stock X for $50 per share. A month from now, its price is $25 per share. A year from now, its price is $75 per share.
Did they lose money? It depends. Did they sell at $25 per share? If so, they lost $2500. If they held it one year, they gained $2500. Even if they didn’t sell at $25 per share, they may have had enough anxiety about the price going down that they are unsatisfied with the $2500 gain.
Risk tolerance is defined as the degree of variability in investment returns that an investor is willing to withstand in their financial planning. Risk tolerance can change over time. For example, a younger investor might want to take on a significant amount of risk to grow his/her portfolio more quickly. A wealthier investor may be more interested in preserving capital and simply keeping up with inflation.
As investors, people tend to overreact to price volatility. They may buy high and sell low because of their fear of missing out and their fear of losing money. But there are many more risks inherent in investing, including (but not limited to) the following.
Business risk is the exposure that an individual business has to certain factors that might lower its profits, lead it to fail or lower its stock price. According to the Foundation for Economic Education, only 53 companies that were on the Fortune 500 in 1955 are still on it today. The companies may have gone bankrupt, merged with another company, or just gotten smaller and, as a result, fell off the list.
Market risk broadly affects all company stocks and is the result of general decline in the economy. This is also sometimes related to other major market or political events.
Volatility risk is the risk associated with the price of an investment going up or down. Many investments are assigned a beta, which is how much the price of a specific investment will fluctuate in reference to an underlying benchmark such as the S&P 500.
Inflation risk is the risk that an investment will not keep up with the underlying inflation. This is critical because inflation may eat away at the value of the investment or at the expected income from the investment.
Liquidity risk is the risk that you may have to wait to sell an investment in order to make it worth the investment.
Risk can be managed but not eliminated. The most basic management strategy is to spread money over many investment ideas such as stocks, bonds and real estate. This includes mixing lower risk investments with higher risk investments. This strategy is called diversification. Diversification can even be performed with a small amount of money by using mutual funds or Exchange Traded Funds (ETFs), which are a convenient and inexpensive way to buy investments that mimic an index such as the S&P 500.
A second strategy to mitigate risk is to buy an investment regularly, regardless of what the market is doing. This tactic takes advantage of the price volatility that regularly exists in the market. This is called dollar cost averaging. In acting on this strategy, one might invest $100 per month into a mutual fund. Sometimes the market price will be higher, sometimes lower, but the overall market volatility will make you money in the long run.
A third strategy is to buy investments and hold them over the long run. Markets tend to go up over time, so patience and consistency may mean cashing in on higher returns, helping to mitigate the effect of inflation on investments.
Ultimately, the real key to successful investing is to have the courage to buy regularly – even when others are fearful and hold your investments for a long time. History has proven that upping one's comfort in investing pays off, over time.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
Teresa R. Sanders, MBA, RICP, CFP, is a partner at Aspen Wealth Management, Inc.