Understanding Investment Risk

Most things we do in life involve some level of risk, but we do them because of their potential rewards. The same is true of investing. Your investments may not always perform as expected or, fingers crossed, they may perform better than expected. When it comes to risk, all investments carry some degree of it. Your investment in stocks, bonds and mutual funds can tumble if the markets turn sour, and even those who invest conservatively may see their investments are not earning enough to keep pace with the cost of living and rising inflation.

To help you make better sense of investment risk and make sound investment decisions, we’ll explain how you can match your risk tolerance to your investment goals to have a healthy portfolio and minimize your risk of loss. 

How Should I Choose My Investments?

In general, investments with higher risk, such as stocks, offer the greatest opportunity for growth over the long term. More conservative investments, such as bonds, usually offer lower risk and earn lower returns. The least risky investments, such as money market accounts and certificates of deposit, provide the lowest growth potential. 

How you choose your investments will depend on your comfort level, or what’s commonly known as your “risk tolerance.” This is just how much of a difference in performance you’re willing to accept whether you feel the potential for a high payoff is worth the possibility of lower earnings or loss.

Are There Ways to Manage Investment Risk?

No one likes the idea of losing money, but here are a few strategies you can follow to help reduce the impact a dip could have on your portfolio.

• Set aside investing dollars for the long term. It's important to keep in mind that there will be ups and downs in the markets. A good rule to follow is not to use money for investments that you’ll need in the next 5 years. 
• Focus on asset allocation. A simple explanation of asset allocation is deciding what percentage of your money will be invested in stocks, bonds or cash equivalents. So, if one asset class doesn’t perform well but another is really performing well, it may balance out losses.
• Diversify. Diversification is key when it comes to managing investment risk and is used by investors so that no single investment is likely to have an outsized effect on the entire portfolio. As the saying goes, never put all your eggs in one basket!
• Consider systematic investing (also called dollar-cost averaging). Historically, we’ve seen that those who invest regular amounts of money at fixed intervals tend to have portfolios that perform better over time. This strategy can help remove the emotion from investing decisions in the short term.

How Much Risk Should I Take?

Figuring out how much financial risk to take is a big decision, and it’s one that’s likely to change as your circumstances change. A lot of it will depend on your investment portfolio goals, how much growth and potential return you want, how long you have to invest and how much you could afford to lose. The closer you get to retirement, the more conservatively you’ll want to invest.

To begin, look at your goals, age and risk tolerance. In addition to your paycheck, include other sources of income (pensions, Social Security, etc.) and assets, as well as your tax situation. Many experts suggest looking for investments that at least cover inflation (historically at about 3%) so that you preserve the value of your money and your buying power.

Still wondering how much risk you’re comfortable with? An advisor from Navy Federal Investment Services can help you determine the degree of financial markets risk you’re willing to accept.

What Are Some Common Investment Terms I Should Know?

Some common investment terms you’ll see regularly include the following:

• Time horizon. There are a few different types of time horizons: short-term, medium-term and long-term, and all relate the period of time an investor expects to hold an investment before they cash it in. A short-term time horizon would be for 2 years, such as saving for a down payment on a home. A medium-term time horizon would be saving for educational goals, such as tuition. A long-term time horizon would be saving and investing for retirement. 
• Purchasing power. Purchasing power and inflation go hand in hand. When there’s inflation, the number of goods and services able to be bought decreases. Purchasing power is the value of a currency expressed in the amount of goods or services that one unit of money can buy.
• Liquidity. Liquidity is how easily you can convert your assets or investments to cash. An illiquid investment means you may not be able to sell quickly because there’s little or no demand for your investment; thus, it’s harder to determine its fair market value.
• Market risk. Market risk is the possibility of experiencing losses due to factors that affect the performance of investments. These can include changes to interest rates, exchange rates, global events such as the COVID-19 pandemic and recessions. Market risk cannot be avoided through diversification of investments.
• Market volatility. A volatile market is unpredictable, so there’s a greater chance that investments could lose value. This usually happens in a difficult economy affecting an entire investment class (e.g., stocks or bonds) or just a particular sector of the market (e.g., technology, energy, health care).
• Currency risk. Often referred to as exchange-rate risk, it arises when one currency changes in price in relation to another. Investors and companies can be exposed to currency risk and unpredictable profits and losses when they have investments in international companies.
• Business risk. This refers to the exposure a company has that will cause its profits to fail. When a company fails to achieve its financial goals, this is a business risk. 
• Credit and credit risk. This is the loss when a borrower fails to repay a loan. When this occurs, the lender may not receive the agreed owed principal and interest, causing interruptions in cash flow and collection costs.
• Default and default risk. When a bank lends money to a borrower, there’s always the risk that the borrower may be unable to make the required payments on their debt obligations.  
• Inflation. When prices rise, buying power is affected. Suppose annual inflation is 3% but your investment only earns 1%. That 2% difference will affect how much you can buy and how much money you’ll make on your investments.
• Interest rate risk. When interest rates rise, the value of a bond or other fixed-income investment will decline. In order to reduce interest rate risk, it’s advisable to hold bonds of different durations. 
• Expected return. This is the profit or loss an investor expects of an investment based on historical rates of return. The goal with expected return is higher returns.
• Foreign investment. Buying foreign stocks may help with the diversification of your portfolio, but it does involve more risk. You’ll also need to account for fluctuations between the value of the foreign money and the U.S. dollar.