Either way there's risk
By Gene Walden
From The Minneapolis StarTribune
We live with risk in nearly every phase of life—every step we take and every decision we make. Allocating your assets is no different. Whether you’re investing in mutual funds or stashing the cash under your mattress, every move you make involves some type of risk.
In the long run, the success you achieve as an investor is determined to a great degree by how you manage the delicate balance between risk and reward.
Even when you think you are eliminating risk—whether by investing your money in a United States government bond or squirreling it away in a safety deposit box—you are still putting your assets at risk.
Safe, low-yielding investments are subject to inflation risk, the possibility that over time inflation will erode the buying power of the asset.
But if you switch your dollars to higher yielding investments, such as a high-yielding bond, you face two other types of risk—interest rate risk (the possibility that if interest rates go up, the value of your bond will go down) and credit risk (the possibility of a bond defaulting) The higher the yield, the riskier the bond.
Since bonds pose risk, why not try stocks or stock mutual funds? Stocks subject you to four kinds of risk—market risk (the risk that the stock market will decline, pulling your stocks down with it), industry risk (the possibility that the industries of the stocks you’ve invested in will hit a slump and drag down the price of your stocks), economic risk (the chance that a declining economy will depress the value of stocks), and individual stock risk (the risk that the specific stocks you own will hit hard times and decline in price).
Wherever you put your money, you face some type of risk. The key to successful investing is to mitigate that risk through time and diversification.
Striking a balance
Time is the ultimate risk neutralizer. If you’re 20 years old and your primary goal is to save for retirement at age 65, you can load your portfolio with high risk, high return investments, such as stocks, with little worries about the risk you’re taking. If those investments do well, that would give you a big head start on your retirement nest egg. If they do poorly, you still have decades to go before you need the money.
That’s why investors in their 20s and 30s should overweight their portfolio with stocks and stock mutual funds. Although they tend to be more volatile in the short term, stock investments typically provide significantly better returns over the long term than most other conventional forms of investment.
On the other hand, if you’re nearing retirement and you feel you have the assets and income stream you need to fund your retirement years, you should probably cut back on the more speculative investments and devote more of your money to safer investments, such as bonds, CDs, annuities, and money market accounts.
One mistake retired individuals tend to make, however, is becoming too conservative with their investments. Thanks to modern medical science, you could live for several decades after your retirement. If all of your money is earning 2 percent in a bank account, inflation could steadily erode your buying power in the decades ahead.
To avoid inflation risk, you should maintain a diversified portfolio, with a portion of your assets allocated to stocks and stock funds designed to provide a better long-term rate of return.
Blue chip stocks that pay a dividend make an ideal investment for retired individuals. Dividend-paying companies tend to raise their dividends year after year, providing shareholders with an increasing stream of income to help counteract the effects of inflation and the rising cost of living.
The other key to managing risk is diversification. Spread your assets around to a variety of stocks or mutual funds that represent a wide range of industries. Then balance that with some fixed income investments, such as bonds, CDs and bond mutual funds. You might also add some real estate investments, such as real estate investment trusts (REITs) to the portfolio.
A broad mix of investments will keep your performance steadier and your blood pressure lower. With several types of assets in your portfolio, if one area takes a hit, the other holdings will keep the portfolio afloat.
Risk is unavoidable in the investment market just as it is in life. Managing that risk is the key to long-term investment success.