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The Ugly Side of Investing: Understanding Investment Risk

The Ugly Side of Investing: Understanding Investment Risk

April 20, 2020
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Risk is a part of life. When you cross the street, you risk getting hit by a car. When you enter into a romantic relationship, you risk having your heart broken. And when you invest your money, you risk losing some or even all of that money. You can’t eliminate risk from your life, but you can make informed decisions that limit the amount of risk to a level you’re more comfortable with. This is especially true when it comes to investing. Risk may feel ugly and frightening, but the more you understand, the better you can handle it.

 If you’re looking for assistance in creating a personalized financial plan, speak with a CERTIFIED FINANCIAL PLANNER™ professional at Good Life Financial Advisors of NOVA today! 

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The Correlation Between Risk and Reward

Especially in investing, there is a high correlation between risk and reward. Higher risk investments often provide an opportunity for higher returns. On the other hand, the safest way to invest your money is in an FDIC insured account—think savings, checking, and money markets. The small amount you’ll earn in these accounts usually fails even to keep up with inflation. Which means, in terms of purchasing power, you could actually be losing money over time. The key to investing is finding a balance between risk and reward that’s appropriate for you. 

Volatility as a Measure of Risk

Measuring risk isn’t always simple. One tool often used to measure risk is volatility, which is a measure of the range of the distribution of returns for an investment. Let’s look at examples of high and low volatility and what they mean for returns:

 Company A is a startup that investors believe has a lot of potential, and therefore may lead to high returns, but it also has a lot of volatility. One day the share price may rise 25%, only to drop 30% the next week. Then there’s Company B. Company B is a large, reliable company that has been around for a while. Company B is unlikely to see as high of a level of volatility. Instead, the share price may see slow, steady gains over the long-term. Company A has a higher potential for returns, but Company B offers investors more stability. 

 While volatility is a useful tool, it fails to take into account the risk of losing your principal investment. Part of what makes investing in Company A so risky is that you may end up with only a percentage of your initial investment. While this is still a possibility with Company B, the chance is much lower, especially if you’re making a long-term investment.  

Time Horizon

One of the most important considerations when choosing the right level of risk for your portfolio is your time horizon, which is when you plan to use the money you’re investing. If you’re five years from retirement or saving for the purchase of a new home, you’ll typically want less risky investments. That’s because, as previously mentioned, higher risk investments often come with higher volatility. If you have a longer time horizon and don’t plan to use your invested funds for decades, volatility should have a much smaller impact.


Reducing Risk Through Diversification

One of the best ways to reduce risk is through diversification. But true diversification is often harder than it seems, since it requires not only investing in multiple stocks, but investing in different asset classes, market caps, sectors, and geographic regions. This way, if an entire sector, geographic region, or even asset class is impacted, your portfolio is not nearly as affected. 

 

Risk and Asset Classes

Another major consideration when it comes to investing and risk is the asset classes you choose to invest in. Different investments come with different levels of risk. Let’s look at four broad asset classes and what they mean for risk: 

Cash 

Keeping your money in cash is the safest option, but it also means you won’t earn any returns. The risk of investing may seem ugly, but what’s even uglier is missing out on the opportunity to make your money work for you.  

Bonds 

High quality bonds, especially those issued by the US Treasury, allow you to take advantage of earning returns with less risk than stocks. Bonds are also referred to as “fixed income” in the investment world. For those with a higher aversion to risk or a shorter time horizon, investing in bonds is a great way to decrease risk. As an aside, investors can invest in a broadly diversified group of bonds around a specific investment objective through mutual funds and ETFs. 

 If you’d like to learn more about how bonds can help reduce your portfolio’s volatility, contact us today to get your Risk Number™. 

Stocks 

Stocks, commonly referred to as “equities” come with more risk, but they also offer more potential for reward. Though as an asset class stocks come with more risk, the amount of risk varies drastically between different stocks. Before you purchase a stock, you should understand the risk associated with it and if it's an appropriate fit for your portfolio. Many mutual funds and ETFs are built specifically to invest in a diversified portfolio of stocks. There are literally thousands of different stock mutual funds and ETFs that invest in equities. These products invest based on broad index, specific sector, style, factors, and any other number of variables.  

Alternatives

So, we’ve covered cash, bonds, and stocks.  What other broad asset classes are there? Enter the world of “alternatives”. Alternatives are often a mystery to the investing public and investment professionals as well. I like to describe alternatives like this. Cash, stocks, and bonds are very different from one another for multiple different reasons. And within those asset classes, there are many sub-asset classes. However, each sub-asset class is going to have certain characteristics that define it as a part of the broader asset class. Alternatives don’t fit neatly into these broad asset classes, so they have their own asset class. hence the title “alternative”.  

While not very creative, it certainly is descriptive. Some examples of alternatives are hedge funds, managed futures, real estate (including REITs), commodities, and a wide array of other strategies. Alternatives are often complex, and should be carefully evaluated prior to adding them to a portfolio.  

The Takeaway 

It’s human nature to want to avoid risk. Investing is not about eliminating risk, but instead about finding the right level of risk for you.  Equally important is understanding the risks in your portfolio and how your various investments behave in different scenarios. If you’d like to explore the topic of risk further, or have a complimentary risk analysis done on your portfolio, contact a CERTIFIED FINANCIAL PLANNER™ professional at Good Life Financial Advisors of NOVA today!

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