Investments Risks and Benefits

In order to reach your financial objectives, you must choose from diverse investment alternatives-all of which vary greatly in the degree and type of risk and potential return. The key to developing a sound portfolio is to strike the right balance between potential reward and risk, based on your financial objectives, financial situation and investment style.

We’ve all heard the expression, “Nothing ventured, nothing gained.” Perhaps nowhere does this maxim hold more true than in the financial markets, where pursuing potentially higher returns means accepting higher levels of risk. Before you venture anything, you should determine your personal level of risk tolerance, given your needs and goals. To do this, you should familiarize yourself with the various kinds of risk and how they affect different types of investments.

The Many Faces of Risk

Risk is the possibility that you may lose some or all of your investment, or that your investment may not increase in value. When investing, you face the following key risks:

Market Risk
This is the possibility that an investment (e.g., a stock) will decline in value. As a result, if you sold the investment, you would receive less than what you initially paid for it.

Credit Risk
This is the possibility that the issuer of an investment (e.g., a corporate bond) may not live up to its financial obligations. A default by the issuer could mean that you lose your invested capital and the expected interest payments.

Inflation Risk
This is the possibility that the value of a long-term asset (e.g., a government bond) may not grow enough to keep up with inflation, reducing your purchasing power as a result.

Reinvestment Risk
This is the possibility that interest rates will fall as an investment (e.g., a bond) matures. If this occurs, you may be unable to reinvest matured assets at the rate of return you were accustomed to receiving. This type of risk also applies to reinvesting the coupon payments received from bonds and other fixed-income payments.

Liquidity Risk
This is the possibility that you will be unable to liquidate an asset (e.g., real estate) when you want and at the price you want. As a result, you may be forced to retain the asset or accept less than you wanted for the sake of liquidity.

National, International, and Political Risk
The possibility that a country’s government will suddenly change its policies. Events such as wars, embargos, coups, and the appointments of individuals with unfavorable economic policies can impact the financial markets, especially concerning investments related to that country. Possible results include changes in tax structures and changes in bond or stock ratings.

Economic Risk
The risk that the economy will suffer a downturn as a whole. Such an event generally affects all the financial markets across the board, from product prices to the job market.

Industry Risk
The risk that a specific industry will suffer a downturn. Often, industries related to the one that experiences problems will suffer as well.

Tax Risk
The risk that high taxes will make investments less profitable for both businesses and investors. Businesses that have to pay higher tax rates often have less capital to go around and, as such, cannot expand or improve. Investments that carry heavy tax baggage generally lead to lower dividends for an investor.

How Much Risk Is Right for You?

To determine your own risk comfort level, ask yourself this: Are you willing to tolerate greater volatility for potentially higher returns from your investments, or do you place more emphasis on quality, with less risk?

Several factors may influence the amount of risk you can comfortably accept in your portfolio, including:

• Your age
• Family situation
• Income
• Financial goals

In addition, the markets evolve and your personal goals will inevitably change with time.

Your Financial Professional Can Help

One of the best ways to keep your investments on target is to meet with your financial professional regularly. In these meetings, you and your financial professional can discuss your investment objectives, determine your individual risk tolerance level and help you understand the various risks associated with an investment.

Your financial professional can also help you build a portfolio that has the potential to provide the highest returns consistent with the amount of risk you wish to assume.

How Can You Choose Which Risks to Take?

Whenever you consider a new investment, you may wish to ask your financial professional the following questions:

What types of risk are involved?
Once your financial professional has explained the risks, ask how he or she can help you to manage or minimize the different kinds of risk for the investment you are considering. Not all kinds of risk will apply to every investment.

What could happen to my principal in a “worst-case” scenario?
Your financial professional can explain how diversifying your portfolio can help mitigate the effect of a downturn in any one market or industry. For example, assume you invested in the stock of a highly speculative biotechnology company. The stock’s trading price could fall substantially if the company’s only product fails to get FDA approval or is shown to be inferior to a competitor’s product.

Spreading your money across different asset classes – stocks, fixed-income investments, and cash equivalents – could help you manage your risk better than investing all your funds in this one stock.

How will adding this investment to my holdings help to manage my portfolio’s overall risk?
Managing market risk through a balance of financial assets in your portfolio is a significant component of long-term investment success. Ideally, your portfolio should offer a measure of protection during inevitable market downturns and be positioned for opportunity when markets heat up.