Interest rates, wars, and economic recession may factor into systematic risk. Systematic risk can be buffered by hedging. Non-systematic risk is also known as “unique risk” because it applies to one company. In general, the more risk you take on as a part of your financial investments, the more profit you stand to gain. Because you can’t predict when these gains will occur, however, careful planning is required to know how much risk you can afford.
Interest risk is the risk that changing interest rates will make your current investment’s rate look unfavorable. Inflation risk is the risk that inflation will increase, making your current investment’s return smaller in relation. Liquidity risk is associated with “tying up” your money in long-term assets that cannot be sold easily.
Two examples of non-systematic risk categories include management risk and credit risk. Management risk is the possibility that bad management decisions will hurt a company in which you’re invested. Credit risk is the chance that a debt instrument issuer (such as a bond issuer) will default on their repayments to you. Keeping different kinds of stocks from a variety of companies helps to defray the risks associated with non-systematic risk.
Cash is the simplest asset, and its main risk is the rate of inflation. Bonds are relatively secure, but they are subject to interest rate as well as liquidity risks (systematic risk), meaning you may not be able to convert them to cash when you need to. Stocks are the most risky investment for a short time period — the fluctuation of the market is a considerable systematic risk — but they often provide a steady income over the long term. Real estate values are relatively stable, though may increase or decrease over time. You may not be able to sell as swiftly as you’d like — real estate is generally considered not to e liquid.
Interest risk rates can change over time, resulting in interest rate risk. If you have a variable interest rate on a loan, you take on the risk that an increased interest rate will change your prospective purchase price. Market risk is the chance that an asset will lose value over time. Liquidity risk is the risk that an asset or security won’t be able to be converted into cash within a necessary time frame.
Stocks are some of the riskiest investments, but can also provide the highest return. Stocks carry no guarantee of repayment, and changing investor confidence can create market volatility, driving stock values down. Bonds are less risky than stocks. Because they are debt instruments, repayment is guaranteed. The risk level of a bond is therefore dependent on the credit worthiness of the issuer; a company with shakier credit is more likely to default on a bond repayment. You must also take into account the interest rate risk, which affects bonds more than it affects stocks. [3] X Research source A rising interest rate means a falling bond price. [4] X Research source Cash-equivalent investments, such as money market accounts, savings accounts, or government bonds are the least risky. These investments are also highly liquid, but they provide low returns.
If you are planning a big expenditure in the near future (such as a house or tuition), or you are retiring soon, you should aim for a relatively low-risk portfolio. This will help ensure that market volatility doesn’t cause your investments to lose a lot of value just before you need to draw money from them. If you are investing for a long-term goal, more risk is appropriate. Long-term goals allow you to wait out stock price fluctuations and realize high returns over the long run.
Allocating assets widely hedges against the risk that certain asset classes will perform well while others perform poorly. Spreading investments between stocks and bonds will protect against the risk of either category performing poorly. Consider using an online asset allocation calculator, such as the one available through the Iowa Public Employees Retirement System. [6] X Research source These tools provide a good framework for understanding ways to allocate your own funds, even though your individual choices will likely vary.
Hedging is not free, and the idea is not to make money from this investment, rather, it is to protect yourself. Consider, for instance, the insurance you pay on your car. If you get in an accident, your insurance may save you hundreds or even thousands of dollars in repairs. On the other hand, you may never get into an accident, but you will have made those insurance payments, just in case. Learn more by reading How to Hedge in Investments.
For example, if you buy stocks in 30 different companies, it is not likely that all 30 will perform poorly or go bankrupt at once, barring an economy-wide downturn. However, if you used the same amount of money to invest in only one company’s stock, the company may perform poorly and drag your entire stock portfolio down with it. Remember that diversification can’t protect against systematic risks. To diversify your portfolio, consider an exchange-traded fund (EFT). An EFT is like a mutual fund in that it is an index of assets (bonds, stocks, futures, etc. ), but unlike a mutual fund, it can be traded like a common stock and has a higher liquidity. [10] X Research source
An example of a shorter time horizon would be a teenager saving for his college education, or someone in their 50s planning for retirement. Long-term investors should be willing (and able) to “ride out” the low points of financial return, i. e. , periods when their assets have lost value. Holding an asset longer doesn’t necessarily result in increased value.
Your risk tolerance will change over the course of your lifetime, though your temperament may not. Someone with a higher risk tolerance may take on more aggressive (and risky) investments, while someone with a lower risk threshold will be happier with a less risky investment, even if it results in lower returns. Think of your risk tolerance level in terms of sleep — anything that causes you to worry and lose sleep at night should be avoided. If there’s an investment that keeps you up at night worrying, then you’ve taken a bigger risk than you’re currently prepared to take.
Rebalancing may trigger transaction fees or tax consequences. Avoid changing your asset allocation based on performance. Remember that if a given asset isn’t doing well, it will likely increase in value in the future. Remember the old adage: buy low, sell high.
