Is R-I-S-K Really a Four-Letter Word?

It is to some—and it is certainly something that most people try to avoid. But in the investment world, risk is impossible to avoid. In fact, risk and long-term rewards are generally related.

Low-risk investments—high-quality bond funds and other fixed-income alternatives—produce more annual income and are more stable, but have no real growth potential.

High-risk investments—diversified stock holdings—can bounce around in value each year, but they offer the potential to grow in value in real, after-inflation terms over long time periods.

That’s why, for long-term investors, risk can actually be a good thing. Indeed, successful long-term investors understand that without the presence of risk, there is no potential for reward.

The trick is to get risk to work for you, and not against you.

How Do You Manage Risk?

Risk is tamed primarily by reducing it down to an acceptable level. Here are several important ways:

  • Use asset allocation to diversify among different asset classes. Bonds and money market funds offer income and stability, while stocks offer growth. Each serves a useful purpose, and you should use asset allocation to diversify across all three classes, even if you want to give primary emphasis to one.

  • Diversify among different fund categories. Don’t view the riskiness of a single fund in isolation. Instead, see how each fund meshes with others you own. A mix of dissimilar funds—for instance, a small-cap stock fund combined with a large-cap stock fund—can calm your overall portfolio.

  • Set your sights on the long term. If you are a long-term investor and have the time to be patient, you can benefit from “time diversification” in your stock holdings. Diversified stock portfolios are volatile year-to-year, but overall the good times have outweighed the bad. If you hold a diversified stock portfolio for many years, the year-to-year variations become less important.

  • Don’t try to “time” the market. Some investors move between the extremes of 100% stocks to 100% cash when they feel the stock market may turn down. You should resist the temptation. Markets are inherently unpredictable. Participation in the best up months is far more important than avoiding the worst down months, and the really dramatic upward surges in stocks are unpredictable and usually of short duration.

  • Be disciplined and use dollar cost averaging. Dollar cost averaging—investing, say, $100 monthly in a specific stock fund—is a great way to build wealth and cope with market ups and downs. Your periodic fixed-dollar investments buy shares during all different kinds of market environments. Your 401(k) plan presents the perfect opportunity both to be disciplined and take advantage of dollar-cost averaging.

There’s no such thing as a risk-free investment. So face risk head-on by understanding and managing it to your advantage.

   The Many Faces of Risk
In the investment world, there are many different kinds of risk. Here are three of the biggest risks facing 401(k) plan investors:

Inflation Risk: Inflation nibbles away at the real value of fixed-income interest and principal payments. Long-term bond funds are particularly vulnerable—they are extremely volatile in terms of principal, and offer no growth over the long term. Money market funds barely keep pace with inflation, and therefore offer no real purchasing power growth.

Market Risk: Corrections and bear markets drag down the returns of even the strongest stocks. Stock portfolios are the most vulnerable over short time periods, when plunges as deep as 30% are possible.

Interest-Rate Risk: When interest rates rise, bond prices fall, lowering the value of existing bonds. Bond fund investors face this risk directly, and the longer the maturity of a bond or bond fund, the greater the risk.