“If you take no risks, you will suffer no defeats. But if you take no risks, you win no victories.” These words from former President Richard Nixon are as applicable to investors as to politicians.
Investors, especially beginners, sometimes forget the fundamental relationship between risk and reward. In developing an investment strategy, one must begin with the realization that it is impossible to secure a return on any investment without incurring some degree of risk.
Balancing risk and reward is one of the most important aspects of managing investments. But to decide how much risk you are willing to take, you must be familiar with some of the major types of risk.
When most people think of investment risk, they focus on price fluctuations in the open market. This is known as market risk or volatility—the risk of a downturn in prices.This is prevalent in today’s financial markets.
There are, however, at least three other risks—inflationary, credit, and interest-rate—that investors should keep in mind. Inflationary risk is usually associated with rising prices that cause the purchasing power of the dollar to decline.
Credit risk is the potential for nonpayment or default on fixed-income investments, such as bonds. Interest-rate risk is the impact of interest rate changes on the value of an investment.
One of the first steps you should take before investing is to establish your tolerance for risk. That is, how much risk are you willing to take for an expected return? Many experts use the “good-night’s-sleep” test as a basis for establishing risk tolerance.
Using this approach, the general rule is that you should not wake up in the middle of the night worrying about your investment portfolio. If your investments cause you to lose sleep, you need to divest yourself of the items that are creating anxiety.
Keep in mind you can reduce your investment risk through diversification. This means not putting all your investment eggs in one basket.
While there is no single correct amount of risk, younger investors can afford higher levels of risk than older ones. They have more time to recover from losses or other adversity.
And as people age, their tolerance for risk tends to diminish. If you are close to retirement, as a prudent investor, you should not take large risks with your retirement funds.
Wayne Curtis, former superintendent of Alabama banks, is a retired Troy University business school dean. Email him at firstname.lastname@example.org.