Investing can be intimidating because the market is unpredictable — what happened in the past doesn’t tell us how the future will go. However, economists can use patterns to get a general idea about how the market might move and can make assumptions about the riskiness of different investments based on these trends. Every time you make an investment, you are taking on a level of risk, including loss of your principal investment, but some investments are riskier than others.
What Is Investment Risk?
Risk refers to the probability that an investment will experience unpredictable price swings. Investments that tend to stay within a narrow range of highs and lows are considered more conservative — they are less risky but the potential for reward is lower. On the other hand, investments that experience more extreme peaks and valleys are considered riskier because there is potential for high returns but also the potential for extreme drops in the value of the investment.
In a nutshell, risk is the chance you take that an investment will have a lower return than expected or even result in losing your investment.
Why Is Market Volatility Risky?
The natural ups and downs of the market are a risk to your investments for a few reasons. First, if you need access to the funds and need to withdraw regardless of performance, you run the risk of withdrawing during a downturn. Many people combat this by leaving money alone for a long period of time so that short-term price fluctuations are leveled off. However, market volatility is still a risk. Why?
Here’s an example: You invested $10,000 in two mutual funds 20 years ago, both with an average return of 10%. The Steady Freddy investment returns exactly 10% every year while the second, Jekyll & Hyde, alternated returns. It could be 5% one year and 15% the next. The average return is the same, so the ending values must be the same, right?
Wrong. Steady Freddy’s final value is actually $2,000 more than the variable returns of Jekyll & Hyde. This becomes even more dramatic if the annual variations were more extreme. Short-term fluctuations in returns are a drag on long-term growth.
Are There Different Types of Risks in Investing?
Yes. There are many different types of risks to investments that you’re probably aware of. For example, an economic disruption like the pandemic shutdowns of 2020 could impact the entire market, a CEO accused of misconduct could cause shares in a company to drop or a new product could shoot share prices up.
Market Risk: Your investments could lose value because of a decline in the market caused by economic, political or social factors.
Inflation Risk: Otherwise known as purchasing power risk, your investments will be worth less in the future because as prices on the whole rise, you will have less ability to pay for goods and services.
Interest Rate Risk: As interest rates rise, the price of bonds fall and vice versa. If you need to sell your bond before it reaches maturation, the principal you have returned to you may be less than you anticipated if interest rates are higher than when you purchased the bond.
Reinvestment Rate Risk: You may need to reinvest funds at a lower rate of return than the original investment, such as when bonds reach maturation.
Default Risk: The bond issuer may not be able to pay the interest or repay principal (also known as credit risk).
Liquidity Risk: Your investments may not be easily converted to cash without loss of your principal.
Political Risk: New legislation or governmental changes (at home or abroad) could impact companies, industries or markets you invest in.
Currency Risk: The fluctuating rates of exchange between your home currency and foreign currencies you invest in will have a negative impact on the value of your investments.
What Is the Relationship Between Risk and Reward in Investing?
The more risk you are willing to live with, the higher your potential returns (and losses). You always want to maximize your investment return without taking on more risk than you are comfortable with.
Your risk tolerance is impacted by how comfortable you are taking risks and your ability to financially deal with a loss. This ability to handle a loss is impacted by your age, where you are in life, your timeline for accessing the money, your investment objectives and your financial goals. For example, a 35-year-old investing for retirement can likely handle a loss better than someone who is just a few years from retirement; someone saving for a dream vacation may be more willing to be risky than someone saving for an upcoming college education.
Talk to an Advisor
Working with a Farm Bureau financial advisor can help you determine the level of risk you are comfortable with and implement strategies to help you mitigate that risk, such as diversification. A financial advisor can also help you find information about the funds you are interested in so you can make well-informed choices about your future.