One of the first steps when investing money is evaluating your tolerance for risk. The amount of return you can earn is heavily dependent on how much risk you are willing to take. We generally associate investment risk with market risk, or the possibility of losing money due to fluctuations in the stock market. The stock market is volatile and can be a high risk investment if you have a short time horizon. However, over long periods of time, the stock market has trended upward. It’s important to consider your tolerance for stock market risk when building your portfolio. However, the risk of losing money due to a drop in the stock market is only one of many risks that can adversely impact your financial security.
Although fixed income investments are generally considered safer than the stock market, they are not without risk. Fixed income investments can include CD’s, bonds, bond funds and cash accounts such as money market or savings accounts. The most common types of risk associated with fixed income investments are interest rate risk and default risk.
Interest rate risk is the possibility of your bonds dropping in value when interest rates increase. When interest rates increase, the value of an existing bond decreases to compensate for higher interest rates available on the market. Generally, if you buy and hold an individual bond till maturity, you will get back the full face value plus any interest that was earned. However, when you own a bond fund, you don’t have control over when bonds within the fund are sold. When interest rates rise, bond managers may be forced to sell bonds at inopportune times due to the large number of withdrawals.
Individual bonds have less interest rate risk than bond funds, but they have a higher degree of default risk. Default risk is the possibility of losing your principal if the bond issuer becomes insolvent. Bond funds are able to reduce the default risk by pooling your money with others and investing in a large number of different companies or municipalities.
Treasury bonds and FDIC insured CD’s provide what is generally considered a risk free rate. If held to maturity, there is very little chance of losing principal. Your investment is insured by the Federal government against default risk, and you have control over when you sell. The primary downfall with this type of investment is the extremely low rate of return.
Investing too much in extremely safe, low earning investments often results in inflation risk. Money placed in “safe” investments with a low rate of return can’t keep up with inflation, resulting in a negative real return. You also lose the opportunity to earn a reasonable rate of return needed to grow your retirement account. It’s all about balance; you need to take some market risk to build and maintain your retirement account and stay ahead of inflation.