Understanding Investment Risk: How to Manage Risk in Investing

A big hurdle to beginning investors is understanding investment risk. The adage is true: nothing in life is certain, and investment risks are a real part of putting your money to work for you. Yes, investing can be intimidating because the market is unpredictable — what happened in the past doesn’t tell us how the future will go. 

However, it’s also true that economists can look at patterns about how the market might move, based on a variety of factors that may or may not be obvious to the average investor. Investment risks are unavoidable, but economists can still make assumptions about the riskiness of different investments based on historical 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. Here’s how to approach investment risk and make informed decisions when investing.

What Is Investment Risk?

Investment risk is the chance you take that an investment will have a lower return than expected, or even result in losing some or all of your money. If you’re willing to take risks, the possibility of reward is real, but by no means certain.

Investments that experience more extreme peaks and valleys are considered riskier because there is potential for high returns, but also the potential loss during drops in value. Investments are considered more conservative when they stay within a narrower range of highs and lows. Investors who are looking for stability typically have more conservative investments, while those who are looking for account growth typically have more investment risk in their portfolio. 

How Does Market Volatility Affect Risk in Investing?

The natural ups and downs of the stock market are a risk to your investments for a few reasons. First, if you need access to the funds you have invested, you run the risk of withdrawing during a downturn, which means turning a paper loss into a real loss. If you were able to ride out the downturn, you may see your account value bounce back, but withdrawing your money means you  may not have the potential for that rebound on those dollars.   

Many people mitigate this risk by keeping their investments untouched for an extended period of time, which means that short-term price fluctuations tend to stabilize over time. However, market volatility is still a risk. Why? The greater price fluctuations mean that higher gains are required to overcome losses. 

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. The Jekyll & Hyde investment alternates 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.

What Are The Different Types of Risks in Investing?

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, such as wars and unrest.

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. This makes new bonds more attractive than ones that were purchased at lower interest rates. 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. This is also known as credit risk.

Liquidity Risk: Some investments, such as real estate, can’t be easily converted to cash, and you may lose 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 the foreign markets you invest in could have a negative impact on the value of your investments.

Risk vs. Reward: Finding the Right Balance for Your Investments

The right risk balance – your risk tolerance – really depends on your personal financial situation, timeline, need for security and comfort with the unknown. 

Your ability to handle a loss may be impacted by your age, your life stage, your dependents, your timeline for accessing the money, your investment objectives and your financial goals. For example, a 35-year-old investing for retirement is generally better equipped to manage a loss compared to 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.

The more risk you are willing to take on, the higher your potential returns (and losses). The key is to maximize your investment return without taking on more risk than you are comfortable with.

Find Your Fit

Connect with a Farm Bureau agent or financial advisor to develop an investment strategy that fits your goals and preference for risk.