Risk. Probably a word that is thought of almost immediately after someone starts discussing investing in the stock market. “That sounds risky.”
It can be.
But do you know what I believe to be far more risky?
Choosing to hold all your cash in a savings account earning close to nothing. The value of your dollar today would continually diminish year over year leaving you with less and less buying power and potentially an inability for you to live the lifestyle you want in the future. Good old inflation.
There is some form of risk associated with each and every type of investment or asset class. Whether you choose to invest in what is perceived to be “safe” or you choose to invest into the stock market, there are inherent risks with each of these financial decisions.
Below is a breakdown of some of the risks connected to our financial choices.
Types of Risk
- Investing in something that requires you to lock your money up for an extended period of time
- An inability to exit a position or investment to withdraw funds at your discretion
- This applies to many different types of alternative investments – Private Equity, Hedge Funds, Real Estate
- Opting to invest in one or more types of asset classes that historically grows at a rate less than the rate of inflation. Thus leaving your assets at risk to lose their buying/purchasing power over time.
- This risk applies mostly to cash but also fixed income as well
- You have opted to invest in the debt of an individual, government institution or company. The credit risk associated with this would be the risk that the borrower is no longer able to pay back their debts due to default and/or credit related issues.
- The risk that you would no longer be paid back your principal and/or interest as it was originally and contractually promised. This would result in a loss on your investment.
- This applies mostly to fixed income and investing in bonds
- By investing, you are inherently risking your assets in a way that they may lose value. This is the risk associated with investing in the market and experiencing the volatility (the ups and downs) that come with it.
- The risk that your investment experiences a loss due to factors impacting the overall market, economy and/or asset class that is beyond your control.
- This applies to most of the asset classes at varying degrees of intensity
- The risk associated with investing in only one asset class and/or specific investment. The risk that comes along with a portfolio that is not diversified.
- You are putting all of your eggs in one basket and subjecting yourself to the volatility and market experience of only one specific investment. This is not going to be a true depiction or reality of investing in the market as a whole.
How Can I Manage Risk? Diversification.
Diversification is the process of investing across multiple different asset classes (cash, bonds, stocks, real estate, etc.) with the ultimate goal of reducing your exposure to risk.
You have the power to control how much or how little risk you take on by the way you choose to invest your portfolio.
Everyone assumes that the risk with investing only relates to the notion that your money could lose value as a result of investing in the stock market. But what people don’t often think about, is the risk that comes into play with each and every financial decision you choose to make.
Let me explain….
If you were to place all of your money into cash – the belief is that you would have little to no risk at all. However, as noted above, one could argue that this decision would be a significant risk in the fact that you are holding all your assets in one asset class that is diminishing in value over time due to inflation.
If you were to place all of your assets into equities – you would be exposing yourself to much greater risk. As now your investments may lose value as a result of the volatility in the stock market.
That’s Why Diversification is So Important
Diversification allows for you to participate in the rewards of being an investor but meanwhile managing the risk and downside you are exposing yourself to. It’s a balance of risk and reward through your selection of investments.
Each investment type will respond in different ways and in varying degrees of intensity to the market. Some investments are directly correlated in that when one goes up the other does as well. And some are indirectly correlated in that when one is seeing momentum, the other will be lagging.
As you build out your portfolio over time, its a balance of playing offense and defense.
Having a diversified portfolio that invests across multiple asset classes, multiple companies in varying industries and market size will be paramount in your desire to reduce or manage your risk.
There is not one single asset class that will provide an avoidance of risk all together
So before you choose to invest in one thing vs. another, it’s important to have a general understanding of the risks associated with it. What other opportunities are you foregoing as it relates to this investment decision. What other factors about your lifestyle or needs should you be considering. How much risk am I willing to take.
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