You can't eliminate risk when you invest, but you can understand it and take steps to keep it at acceptable levels. Let's look at six types of investment risk and some ways to mitigate them.
1. Market risk: A stock will rise or fall in price in response to investor sentiment or changes in the fortunes of the company or the industry it's in.
2. Interest rate risk: When interest rates rise, fixed-income investments (such as bonds) lose value. (Of course, rising interest rates increase the cost of doing business for most companies and can also, thereby, raise market risk.)
3. Inflation risk: Rising inflation can erode the value of income and/or assets.
4. Credit or default risk: When a borrower can't repay a loan, someone loses money.
5. Currency or exchange risk: If the value of the U.S. dollar rises in relation to other currencies, the value of foreign stock shares translates into a smaller number of dollars in the U.S. for investors who hold those shares. Put another way, a "strong" dollar can buy more foreign goods, including foreign stocks. Conversely, if the dollar falls in relation to other currencies, the value of foreign stock shares rises, as more "weak" dollars are needed to buy a given amount of foreign stock.
6. Timing risk: Whenever you make an investment, you're betting that its value hasn't already peaked, that better days lie ahead.
Risk Reduction Strategies
1. Diversify. Financial advisors generally agree that most types of risk can be managed by diversification dividing investment dollars among different industries, countries, and asset classes (stocks, bonds, real estate, etc.). "Spreading the risk" through diversification helps cushion the impact that problems in one investment might have on a portfolio.
Mutual funds have become popular investment vehicles partly because they enable individual investors, who often lack the resources and expertise to achieve adequate diversification on their own, to gain instant diversification through a professionally managed portfolio. For example, a fund like the Pax World Balanced Fund always invests at least 25% of its assets in income-producing securities to offset the higher risk of its stock-market holdings. And within its stock portfolio, the Fund diversifies among various industries to spread the market risk further.
2. Be patient. Research by Chicago-based Ibbotson Associates, Inc., shows that very high stock-market returns occur only over short periods. On the other hand, losses disappear almost completely over ten-year holding periods, and they vanish over 20-year holding periods. The message: to reduce risk, invest for the long term.
3. Jump in gradually. Lump-sum investing can produce spectacular returns - if your timing is right. That's a big "if." Few professional investors consistently "time" the market correctly, and individual investors are notorious for timing it incorrectly, buying in droves at market tops and selling in droves at market bottoms. For most investors, dollar-cost averaging investing a fixed amount of money on, say, a monthly basis provides a disciplined approach that can reduce investment risks and improve long-term returns.
Written by: Pax World Fund Family. The Pax World Fund Family offers a range of socially responsible mutual funds, all of which offer automatic investment plans and several types of tax-advantaged accounts to choose from. You should read the fund prospectus carefully before investing or sending money.
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