Understanding different types of risks and your objectives
If you participate in an employer sponsored retirement plan or save on your own accord into an individual retirement account, do you know how it’s invested? Do you know how those investments behave over time to changes in the marketplace? Do you understand the different types of risk you are undertaking?
It’s ok if you answered no to these questions. Most people probably will. Here is the problem, if you don’t know how you are invested then you don’t know how much or what kind of risk you are taking with your money. A simple gauge for assessing the potential risk level in a particular investment is to look at how much its returns are liable to vary from year to year. Let’s draw a comparison. A bank certificate of deposit (CD) for instance will be very stable and the return easily calculable. An investment in a stock mutual fund on the other hand will have a much greater range of possible returns from year to year with much less predictability. What you want a particular pool of money to do for you, and the period of time it has to stay invested, will largely dictate how it should be positioned. However, there are other components to the equation.
How you feel about variability also plays a key role. It is generally understood that when we lose money, or perceive we have lost money, it is far more impactful on how we feel than when we make money. If you found a 100 dollar bill in the parking lot it might make your day. If you dropped that 100 dollar bill in the parking lot it might sting for several days.
Other factors like your capacity for risk or the security of your overall financial situation will also help determine your ability to take on risk. If you have an adequate emergency fund, life insurance, and short term/long term disability coverage, then your financial risks are fairly well covered, allowing additional savings to be exposed to greater risk to help you reach your longer term objectives.
Remember, with risk comes return. The more risk, generally speaking, the higher potential for growth over time which for most investors is a key objective. Risk isn’t bad. Just know how much and what kind of risk you are taking with your money so you are an informed investor. If you are not sure how to assess investment risks, then ask for help from someone who does. Don’t leave yourself open for surprises. After all, it’s your money we are talking about.