Dealing with Investment Risk

2006-05-10

Whether you are just starting out or you are a seasoned investor, risk should always play a role in your decision before you invest. Although most people see the importance in evaluating risk, some ignore just ignore it due to a lack of understanding. There are certainly a lot of risks to consider. Things like: concerns over stock prices that are too high, companies who fail to meet expectations, terror attacks and their effects on our global economy, shady CEO’s, and the list goes on.

In order to better understand risk, we must first define what risk is. But the problem is people view risk differently, therefore define it differently. Some view risk simply as the possibility of losing money. Some think of risk as market volatility or an individual stock’s volatility based on historical data. So define it as a combination of factors. As an investor, only you can decide what your risk comfort level is.

Some level of risk must be taken in order to realize any level of return, after federal taxes and inflation. For instance, if you were to place your money into a CD with a 4% interest rate. Your net return on investment after taxes, but before inflation, would be 2.7%. Now if inflation were to run 3% in that given year, in essence you would realize a 0.3% loss on your investment. This is called inflation risk.

So what’s the solution, according to many financial advisors, even those in their retirement years should keep a certain percentage of their investments in the form of stocks. Historically, stocks have out gained inflation by about 7% a year.

This is where diversification comes into play. The amount of diversification you should bear again depends on what your individual needs and investment goals are. You can diversify your holdings either on your own by investing in individual stocks, bonds, real estate, commodities and CD’s / savings accounts. Or you can go with one of the various funds that are available in the market. These funds help to minimize your risk.

The way fund managers accomplish this is by creating funds that are made up of several individual stocks. These are usually done by market segments, such as healthcare, utilities, blue chips, growth companies, etc. The list is virtually endless. You can even by funds that are made up of all the stocks in the market. The problem with these funds is that, many carry large administration fees.

The idea behind diversifying to manage your risk is that if one segment of the market is performing poorly, another area may be doing very well thus balancing the scale.

For more tips on investing read the related articles below.

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» Are Mutual Funds Really Worth It
» Benefits of opening an IRA
» Getting Bigger Returns on Your Investments

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