All investments involve risk but some investments are riskier than others. To avoid your own 'risky business' scenario, it helps to understand all the many dimensions of risk.Then you can make investment decisions that will work for you,” says Pat Swanson, CFP® and families specialist with Iowa State University (ISU) Extension’s Invest Wisely Project (www.extension.iastate.edu/investwisely).
Swanson explains that lower risk investments, such as government bonds, guarantee you will receive the principal back plus interest but they may not keep up with inflation. On the other end of the spectrum, if you invest in commodities the returns may be substantial but the risk of losing is very high. “The time to understand your risk tolerance and the risks in your proposed investment portfolio is before you make your investments.”
Investments such as stocks may help you beat inflation, but they are subject to other kinds of risk. One is business risk,which is associated with a particular company or industry. For example, one company’s profits may be adversely affected by a lawsuit or by competition. Or a new government regulation may cause the price of stocks in a particular industry (pharmaceuticals for example) to drop.
Market riskis associated with volatility of the financial markets in general. A stock's price may fall because the overall stock market has dropped.
If you invest in bonds you are assuming that the interest rate earned will beat inflation and the interest will be paid and you will receive your principal back. Fixed-income securities are affected by interest rate risk. When interest rates increase, new bonds pay a higher interest rate than those issued during earlier periods of lower interest rates, Treasury securities issued by the U.S. government have the lowest risk; junk bonds have much higher risk.
Swanson says a pyramid is a good way to visualize the place of risk in your portfolio. “Your investment portfolio should be built on a broad, financially secure base – a home, emergency fund, adequate insurance. On the next level you can include some mutual funds that invest in low-risk, dividend-oriented stocks and top-quality government and corporate bonds. Individual stocks and bonds also would fit here.”
Investment real estate would be on the next level of this pyramid. "And at the top are investments that few people should try – small company stocks, commodity futures contracts, and most limited partnerships – these are all high risk investments that may pay off, or may not.”
Although it might be scary to some, Swanson emphasizes it is important to accept risk. “You cannot hope for higher returns without accepting some changes in the value of your portfolio over time. Consider that the longer your time horizon, the more likely it is that stocks and stock mutual funds will outperform cash and bond investments.”
“To choose your personal level of risk,” Swanson says, “think about your goals, age, income, resources and current and future financial obligations. If you are a younger single person who expects your salary to increase over the years and you have few family responsibilities, you can afford to take more chances than if you are a couple approaching retirement age. A younger person has time to recover from market loses; an older couple may not.”
The ISU Extension Invest Wisely Project provides a series of newspaper, radio, and web resources for investors. It is funded by a grant from the Investor Protection Trust (IPT). The IPT is a nonprofit organization devoted to investor education. Since 1993 the IPT has worked with the States to provide the independent, objective investor education needed by all Americans to make informed investment decisions. www.investorprotection.org.