A Realistic Perspective on Risk
09/01/2010 - How much risk are you as an investor willing to accept? This is one of the most important factors that can affect the way you structure your portfolio and your overall financial plan. Yet it is also one of the most difficult to quantify. There is no universally accepted way of accurately measuring an investor's risk tolerance. A number of factors come into play, including the investment and economic environment you are dealing with at the moment.
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For example, consider how you might have answered a question about your level of risk tolerance during the record bull market of the 1990s. Given that the market rarely experienced an extended down period during that decade, many investors were comfortable implementing an investment strategy that was quite aggressive. They were convinced there was little chance that the stock market would suffer a significant setback.
Things look a lot different today. We've had two notable bear markets in less than a decade. The Standard & Poor's 500 stock index (an unmanaged index of stocks) lost 49% from 2000 to 2002, and after recovering and reaching new highs, lost another 57% from late 2007 to early 2009. This experience has likely caused you to reconsider how much risk you are willing to accept. Today's investor truly understands what it means to deal with investment risk. It isn't just a theory like it was during the 1990s, but a real possibility. Facing that reality, investors know they have to take risk more seriously, and try to determine their appropriate risk tolerance level.
Assessing your own risk profile
Here are some ideas to keep in mind as you define your own views about investment risk:
• Set proper expectations. It's important to accept that stock investments will be subject to periodic volatility. The reward potential of investing in future growth of global businesses remains strong, but the path to wealth is not always smooth. Prepare yourself for the fact that it will get bumpy along the way.
• Try to maintain a consistent investment behavior. Take an objective view of your investment goals. Combine that with an honest appraisal of how much fluctuation you are willing to accept with your portfolio. Invest accordingly and stick with that strategy. Don't let short-term swings and day-to-day headlines sway your long-range resolve as an investor.
• Recognize that time is one of the biggest determinants of risk tolerance. Investors with a decade or more to reach their goal have the luxury of riding out market downturns or even extended flat or negative markets. Those who expect to reach their goals in the next few years need to take steps to protect against the impact of market volatility. Your risk tolerance level may need to be adjusted as you grow older.
• Trust your instincts. If you have trouble sleeping at night because of concerns about the safety of your investments, it may be time for a change. But be sure that any decisions you make align with your ultimate financial goals.
• Explore ways to stay invested in the market while mitigating some of the risk associated with it. Dollar-cost averaging into investments rather than investing lump sums at one time is one option. Maintaining proper diversification across a variety of asset classes is another. Products (such as variable annuities) that allow you to continue to participate in the market's growth potential while locking in gains are also worth considering.
Remember other risks
While the risk of losing money in an investment is always foremost in your mind, don't overlook other potential risks. Among them:
• Purchasing power risk – inflation is always a factor. Simply stated, your money won't be worth as much in the future as it is today. It is important to own investments that can help your asset base at least keep pace with inflation, and hopefully grow faster than the cost of living.
• Opportunity risk – missing out on potential profits in a specific investment by choosing to have your money in a "safe" place or being unable to access money for a period of time in order to put it to work in a more effective way.
• Interest rate risk – fixed income instruments such as bonds carry their own risks, one of them being that if interest rates rise, bond values will decline. Given that yields are currently at historically low levels, this risk may be more significant today.
Managing risk in an effective way will play a role in determining your ultimate investment success. It is an issue to take seriously and to deal with honestly.
Brokerage, investment and financial advisory services are made available through Ameriprise Financial Services, Inc. Member FINRA and SIPC. Some products and services may not be available in all jurisdictions or to all clients.
The Standard & Poor's 500 Index (S&P 500® Index), an unmanaged index of common stocks, is frequently used as a general measure of market performance. The index reflects reinvestment of all distributions and changes in market prices, but excludes brokerage commissions or other fees. It is not possible to invest directly in an index.
Diversification helps you spread risk throughout your portfolio, so investments that do poorly may be balanced by others that do relatively better. Diversification and dollar-cost averaging do not assure a profit and do not protect against loss in declining markets.
Variable annuities are insurance products that are complex long-term investment vehicles that are subject to market risk, including potential loss of principal invested.
There are risks associated with fixed income investments, including credit risk, interest rate risk, and prepayment and extension risk. In general, bond prices rise when interest rates fall and vice versa. This effect is usually more pronounced for longer-term securities.
Investment products, including shares of mutual funds, are not federally or FDIC-insured, are not deposits or obligations of, or guaranteed by any financial institution and involve investment risks including possible loss of principal and fluctuation in value.
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