Is R-I-S-K Really a Four-Letter Word?
It is to someand 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 investmentshigh-quality bond funds and other fixed-income alternatives—produce more annual income and are more stable, but have no real growth potential.
High-risk investmentsdiversified stock holdingscan 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 fundsfor instance, a small-cap
stock fund combined with a large-cap stock
fundcan 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
- 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 averaginginvesting, 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.
|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
Inflation Risk: Inflation nibbles away at the real value of fixed-income interest and principal payments. Long-term bond funds are particularly vulnerablethey 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.