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The Online Advisor - August 1999
Can you avoid risk in your investments?
There are several different kinds of investment risk.
To understand this concept, consider Bob and Martha. Bob hopes to avoid risk, so he invests in ultra-safe U.S. government securities. Martha is more adventuresome, so she invests in stock mutual funds.
In the short run, the value of Martha's investment will probably bounce around more than Bob's investment. Most people would say that Martha's portfolio is "riskier" than Bob's, because Martha is subject to the ups and downs of the stock market.
But in the long run, Martha's stocks are likely to be worth more than Bob's government securities. Based on history, Martha's investment also should grow faster than the inflation rate, even after considering taxes. Bob will be lucky if his investment even keeps up with inflation.
The many kinds of risk
The truth about investing is that every portfolio contains risk, although the nature of the risk varies. A portfolio that contains government securities, like Bob's, is subject to "inflation risk." A portfolio heavily invested in stocks, like Martha's, is subject to "market risk."
What about a portfolio that holds corporate or municipal bonds? It is subject to inflation risk, and it's also subject to "default risk" -- the possibility that one or more of the bond issuers will fail to make an interest payment.
Real estate investments historically have appreciated faster than the inflation rate, but real estate is subject to "liquidity risk" -- the possibility that nobody will want to buy your property at an acceptable price when you are ready to sell. Certain types of stock are also subject to liquidity risk.
How to cut risk
In a world where every type of investment is subject to risk, usually the best strategy is to spread those risks around. In other words, diversify.
Younger people will generally want to tilt their portfolios toward stocks and stock mutual funds, but even retirees should consider owning some stocks to help offset inflation risk. On the other hand, young people shouldn't go overboard with stocks, since fixed-income investments can help balance market risk.
You can't escape risk in the world of investments, but you should try to choose the investments that fit both your risk comfort level and your personal financial situation.