Understanding risk

Everything we do or dont do has an element of risk to it. What are the risks of investing and how can you get comfortable with them?

When you make an investment, you risk the possibility that the value of your investments will go down or remain unchanged over time. Some investments are more risky than others. Generally, the more risk youre willing to take, the greater your opportunity for reward over the long term.

Theres not a simple formula to follow to determine how much risk is worth taking; only you know how much or what kinds of risk youre comfortable with. Whats more, your willingness to accept certain levels of risk will probably change during your lifetime.

Start to determine your comfort level with risk by asking yourself two questions:

1. What are my retirement goals?

The more specific you are, the easier it will be to determine the level of return youll need and the level of risk youll need to accept to potentially reach those goals.

2. When do I want to retire?

If retirement is a long way off, you might consider more aggressive investments. A span of several years gives you the opportunity to ride out the ups and downs of a number of market cycles. But if youre close to retirement, you might want to shift to investments with lower risk. In either case, talk to a financial professional to see what makes sense for your situation.

Next, youll need to evaluate your investment options. Most investments fall into one of three broad categories:

• Stocks and stock funds Historically, these have offered the highest potential reward but tend to have the highest risk and are more appropriate for long-term investors.
• Bonds and bond funds These typically present less risk than stocks but generally have less growth potential than stocks.
• Cash equivalents This category includes money market funds or stable value funds and offer the least volatility. Investors generally use them to help preserve what they’ve invested.

See how these types of investments compare.

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Dealing with risk

Losing money is an obvious risk with any investment, but there are others you may not have considered:

Risk of inflation

Inflation eats away at the value of a dollar. If your investments dont keep pace with the rising cost of living, youve lost buying power. Over the past 50 years, the inflation rate has averaged around 4%. Among the types of investments covered here, only stocks and bonds (or funds investing in them) have consistently surpassed that rate over the long term.

If you are a conservative investor or will be retiring soon, you may be attracted to cash-equivalent investments. Consider including enough stock or bond fund investments to keep you from falling behind rising costs. Keep in mind that much of your investment portfolio might still have a 10- to 30-year time horizon once you retire.

Market risk

Another word for market risk is volatility. Volatility makes it more likely you could lose money if you need to sell your investment in the near future.

One way to address market risk is to diversify your investments and to continue contributing regularly over a long time period. Theres no guarantee that putting your money in a variety of investments will eliminate risk, but it has helped in the past.

Merits of diversification

By including a mix of stock and bond funds for your portfolio, gains in one or more of your investments might balance or offset losses in the others.

Riding out cycles

Investing over the long term wont guarantee you a profit or prevent you from losing money, but making a regular fixed-dollar investment (called dollar cost averaging) can help compensate for the natural up and down cycles in the market. Because the prices of mutual funds fluctuate, dollar cost averaging allows you to buy more shares when prices are lower and fewer shares when prices are higher. As a result, it can lower your average cost per share. Before using this strategy, though, make sure to consider your willingness to continue investing while share prices are declining.

Investing abroad involves risks, such as currency fluctuations, periods of illiquidity and price volatility, as more fully described in the prospectus. These risks may be greater with investments in developing countries. Though there are risks associated with investing outside our borders, the global marketplace has a lot to offer most investors. Foreign markets often move in their own market cycles, so investing abroad may help to counteract the effects of a down U.S. market on your portfolio.

Investments are not FDIC-insured, nor are they deposits of or guaranteed by a bank or any other entity, so they may lose value.