Investing is a great way to meet your long-term financial goals and to grow your wealth faster than by keeping your money in a savings account. But when you purchase assets like stocks and bonds from which you hope to earn a profit in the future, there's always going to be some risk involved.
Investment risks can be hard to come to terms with, especially for people who are just starting out. Finding the sweet spot between too much risk and not enough can be tricky. You don't want to take so much risk that you ruin your chances of retiring comfortably, but you also want to take on enough risk to generate growth.
Ultimately, understanding risk can help you create a plan to weather market ups and downs, so you're better able to stick with it in the long term and end up reaching your financial goals, says certified financial planner Marguerita Cheng, CEO of Blue Ocean Global Wealth in Gaithersburg, Maryland, and a member of the CNBC Advisors Council. After all, she says, "the hardest part about investing is staying invested."
Here are four of the most common risk factors with investing in stocks and bonds.
When you invest in the stock or bond markets, you're taking on what's known as systematic risk. That means that if there's a broad decline in the market, your investments could lose value.
Everything from an economic recession to political strife can cause the markets to slump and lead to investor losses. As investors have experienced during the coronavirus pandemic, market risks can be hard to predict.
There's no telling when the market may hit a rough patch or if your returns may not meet your expectations.
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"In general, with investing, you're always paid to take on more risk," says Chad Hamilton, a certified financial planner and the director of practice management at Brown & Company in Denver, Colorado. Historically, the stock market has an annual return of around 10%, which is significantly higher than the current best-available savings account rate of 1.5%.
For long-term investors saving for retirement, diversifying your portfolio among different assets helps manage market risk because different investments, companies, and industries won't always react to market-moving events in the same way, or to the same extent. "It's important to tell people that every investment has risk," says Cheng.
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Concentration risk is when you have too much exposure to a single company or sector in your portfolio. You're putting too many of your eggs in one basket, so to speak.
Even so, it's important to review those investments. Even if you hold multiple stocks within a single fund, you may still be prone to concentration risk if those companies are focused in particular segments, or if your portfolio weights heavily in one market market sector, such as transportation or utilities.
When you invest in bonds, you're lending money to a company or the government, typically at a fixed interest rate. You're taking on part of a company's debt obligation, says Cheng. You can generally expect to get your money back, but you won't if the company goes under and defaults on its debts. That's default risk.
Look to yield as a risk gauge: When investors put their money in bonds that have a higher chance of default, they want to be compensated for that risk in the form of greater returns. For example, so-called junk bonds have high returns because analysts think there's a greater likelihood of default. U.S. Treasury bonds, on the other hand, are considered among the safest investments because the government has never defaulted on its loans, but tend to have lower yields.
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"Sometimes people will say, 'Hey, I want to go to bonds because I don't want to lose money.' What's interesting is a high-yield bond may actually behave more like a stock," says Cheng.
You can mitigate default risk while also tapping into higher yields by having a mix of different kinds of bonds in your portfolio.
Normally, the longer a bond has until maturity, the higher its yield, explains Hamilton. That means the yield on longer-term bonds (typically 30-year Treasury bonds) is greater than that on shorter-term bonds (1 to 3 years) because investors demand a better return in exchange for surrendering their money for a longer period of time.
Interest rate risk is the possibility that your bond investment will lose value as a result of rising interest rates over the duration of your investment.
"The problem with buying a bond that matures in 30 years is that interest rates are at an all-time low," says Hamilton, and so are sure to rise at some point in the next three decades, cutting into your return.
You can protect against interest rate risk by holding bonds of different maturity dates, creating what's known as a "bond ladder."
As you learn about the common risks on stock and bond returns, recognize that there's no one right way to allocate your assets. The right proportion depends on factors like your age and overall tolerance for risk. Baltimore-based money managers T. Rowe Price suggest these goals:
Understanding the risks associated with investing, and what you can do to hedge against them, can help you manage and even embrace risk. That way, you can get a better sense of your comfort level with risk, and stay on track to meet your financial goals.
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