Risk is a fact of many aspects of life. It’s usually regarded as a negative, involving the possibility of loss, but it also can be a step toward potential rewards and lead to a more fulfilling life. The key is to understand what risks you face and are willing to take.
This applies especially to investment risk, and can take several forms. As you review your financial goals and create a plan to pursue them, risk and potential reward are part of that process. After all, the better you understand the different types of risk and how they come about, the more effectively you can strategize as you build a plan.
Here are some common types of investment risk that you should understand as you review your portfolio:
All investment asset classes fluctuate, going up or down as they are influenced by market or economic factors. Fortunately, however, different asset classes don’t usually move in tandem. Therefore, if you diversify across various asset classes, such as stocks, bonds and cash equivalents, you may help ease the impact of a market decline on your portfolio.
Investors who buy foreign stocks or mutual funds face the possibility that investment returns may be reduced by a rising U.S. dollar. A declining dollar, on the other hand, may help increase the value of international holdings. Foreign investments also may be affected by differing economic or political conditions in the respective country.
Fixed-income investors face the risk that the company issuing a bond will not be able to pay principal and interest in a timely manner. You can choose “higher-rated” bonds in an effort to help manage this risk, or you can choose a professionally managed mutual fund that invests in various types of bonds, meaning that one default may not impact the fund’s overall performance.
Interest rate risk
Rising interest rates can affect the stock market, but they particularly impact the bond market, since the value of existing bonds generally declines when rates rise. Bonds with long maturities are especially vulnerable to this risk. Mutual funds with varied maturities may help offset some risk.
Industry or “sector” risk
Just as the broad market sometimes declines, so do specific sectors within the market. These differing declines are generally due to developments in a particular industry. For example, technology stocks and products were in high demand in the mid- to late-1990s, but then declined during the subsequent bear market. Stocks within an industry may move in tandem, so you may want to diversify your portfolio, potentially decreasing adverse effects from the decline of one sector.
As with your daily life, you will face some risk in your investment portfolio and in your long-term investment plan. Talk to your financial advisor about the types of risk, and how to best manage them over time.
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Diversification will not ensure a profit or guarantee against a loss in a declining market. Please note that mutual funds will fluctuate in value and an investor can lose money by investing in mutual funds.
Please note that the information provided may include references to concepts that have legal, accounting and tax implications. It is not to be construed as legal, accounting or tax advice, and is provided as general information to you to assist in understanding the issues discussed. Neither Waddell & Reed, Inc., nor its Financial Advisors give tax, legal, or accounting advice.
This information is not meant as financial or investment advice pertaining to your personal situation. The selection of appropriate investment, insurance or planning options and/or strategies should be made on an individual basis after consultation with appropriate legal, tax and financial advisors. Nothing contained herein is intended as a solicitation or an offer to buy or sell any product or service mentioned and they may not be suitable for all investors.
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