UNDERSTANDING RISK Few terms in personal finance are as important, or used as frequently, as "risk." Nevertheless, few terms are as imprecisely defined. Almost universally, when financial advisors or the media talk about investment risk, their focus is on the historical price volatility of the asset or investment under discussion. Advisors label as aggressive or risky an investment that was prone to wild price gyrations in the past. The presumed uncertainty and unpredictability of this investment's future performance is perceived as risk. Assets characterized by prices that historically have moved within a narrower range of peaks and valleys are considered more conservative. Unfortunately, this explanation is seldom offered, so it is often not clear that the volatility yardstick is being used to measure risk. Before exploring risk in more formal terms, a few observations are worthwhile. On a practical level, we can say that risk is the chance that your investment will provide lower returns than expected or even a loss of your entire investment. More to the point, you are concerned about the chance of not meeting your investment goals. After all, you are investing now so you can do something later (e.g., pay for college, retire comfortably). Since every investment carries some degree of risk, it makes sense to understand the kinds of risk as well as the extent of risk that you choose to take, and to learn to manage it. What you probably already know about risk Even though you might never have thought about the subject, you are already familiar with many kinds of risk from life experiences. For example, you know intuitively that a scandal or lawsuit that involves a particular company will likely cause a drop in the price of that company's stock, at least temporarily. You assume that if one car company hits a home run with a new model, that would be bad news for all competing automakers. In contrast, you'd expect an overall economic slowdown and stock market decline to hurt companies and their stock prices across the board, not just in one industry. You must be mindful of these and other kinds of risks going forward. Volatility is a good place to begin, however, as we examine the elements of risk in more detail. Volatility--why is it risky? Suppose that you had invested $10,000 in each of two mutual funds 20 years ago, and that both funds produced average annual returns of 10 percent. Imagine further that one of the funds, Steady Freddy, returned exactly 10 percent every single year, unlike any real investment. The annual return of the second fund, Jekyll & Hyde, alternated--5 percent one year, 15 percent the next, 5 percent again in the third year, and so on. What would these two investments be worth at the end of the 20 years? It seems obvious that if the average annual returns of two investments are identical, so will be their final values. But this is a case where intuition is wrong. If you plot the 20-year investment returns on a graph, you'll see that Steady Freddy's final value is over $2,000 more than what you'd get from the variable returns of Jekyll & Hyde. The shortfall gets much worse if you widen the annual variations (e.g., try plus-or-minus 15 percent, instead of plus-or-minus 5 percent). This example illustrates one of the effects of investment price volatility: Short-term fluctuations in returns are a drag on long-term growth. Although past performance is no guarantee of future results, historically the negative effect of short-term price fluctuations has been reduced by holding investments over longer periods. But counting on a longer holding period means that some additional planning is called for. You should not invest funds that will soon be needed into a volatile investment. Otherwise, you might be forced to sell the investment to raise cash at a time when the investment is at a loss. Other types of risk Here are a few of the many different types of risk: Market risk: This refers to the possibility that an investment will lose value because of a general decline in financial markets, due to one or more economic, political, or other factors. Inflation risk: Sometimes known as purchasing power risk, this refers to the possibility that prices will rise in the economy as a whole, so your ability to purchase goods and services would decline. For instance, your investment might yield a 6 percent return, but if the inflation rate rises to double digits, the invested dollars that you got back would buy less than the same dollars today. Inflation risk is often overlooked by fixed income investors who shun the stock market completely, fearing the risks found there. Interest rate risk: This relates to increases or decreases in prevailing interest rates and the resulting price fluctuation of an investment, particularly bonds. There is an inverse relationship between bond prices and interest rates. As interest rates rise, the price of bonds falls, and vice versa. If you need to sell your bond before maturity, you run the risk of loss of principal if interest rates are higher than when you purchased the bond. Reinvestment rate risk: This refers to the possibility that you will have to reinvest funds at a lower rate of return than the original investment. Your five-year, 3.75 percent certificate of deposit might mature at a time when your only choice is to buy a new certificate of deposit at just 3 percent. Default risk (credit risk): This refers to the risk that a bond issuer will not be able to pay its bondholders. Liquidity risk: This refers to how easily your investments can be converted to cash. Occasionally (and more precisely), the foregoing definition is modified to mean how easily your investments can be converted to cash without significant loss of principal. Political risk (for those making international investments): This refers to the possibility that changes in foreign governments or politics will adversely affect the financial markets there or the companies you invested in. Exchange risk (for those making international investments): This refers to the possibility that the fluctuating rates of exchange between U.S. and foreign currencies will negatively affect the value of your foreign investment, as measured in U.S. dollars. The relationship between risk and reward In general, the more risk you're willing to take on (whatever type and however defined), the higher your potential returns, as well as potential losses. This proposition is probably familiar and makes sense to most of us. It is simply a fact of life--no sensible person would make a higher-risk, rather than lower-risk, investment without the prospect of a higher return. That is the tradeoff. Your goal is to maximize returns without taking on more risk than you can bear. Understanding your own tolerance for risk The concept of risk tolerance is twofold. It refers to both your personal desire to assume risk and your financial ability to endure risk. It also assumes that risk is relative to your own personality and feelings about taking chances. If you find that you can't sleep at night because you're worrying about your investments, you've assumed too much risk. Your financial ability to endure risk has more to do with your age, stage in life, how soon you'll need the money, and your financial goals. If you're investing for retirement and you're 35 years old, you can endure more risk than someone who is 10 years into retirement, because you have a longer time frame before you need the money. With 30 years to build your retirement fund, you have the ability to withstand short-term fluctuations in hopes of a greater long-term return. Reducing risk through diversification Don't put all your eggs in one basket. You can help offset the risk in any one investment by spreading your money among several asset classes. Diversification strategies take advantage of the fact that forces in the markets do not normally influence all types or classes of investment assets at the same time or in the same way. Swings in overall portfolio return can be smoothed out by diversifying your investments among assets that tend not to experience price fluctuations that mirror each other. In a slowing economy, for example, stock prices might be going down or sideways, while falling interest rates cause the price of bonds to rise. In addition to diversifying among asset classes, you should consider diversification within an asset class. There are different types of investments within an asset class. For example, when investing in stocks, you can choose to invest in large companies that tend to be less risky than small companies. When investing in bonds, you can choose between Treasury securities and the more risky corporate securities. Or, you could decide to allocate a portion of your investment funds among all four types of investments. Diversifying within an asset class helps reduce the risk to your portfolio due to the impact of any one particular type of stock, bond, or mutual fund. Evaluating risk--where to find information about investments You should become fully informed about a product before you invest. There are numerous sources of information about investment products. You can find information in third-party business and financial publications and websites, as well as annual and other periodic financial reports. Obtain a prospectus if the investment is a mutual fund or an initial public offering, or an offering circular if the investment is a limited partnership or hedge fund. Third-party business and financial publications can provide credit ratings, news stories, and financial information about a company. For mutual funds, third-party sources provide information such as ratings, financial analysis, and comparative performance relative to peers. The prospectus for a mutual fund provides a vast amount of information, including the fund's investment objectives, the types of securities it invests in and risks that go along with those securities, past performance, expense information, and financial reports. If you are considering investing in an initial public offering (IPO), it is extremely important that you read the prospectus. The prospectus contains information about the company's products and/or services, operating history, future prospects, and management. The offering circular of a limited partnership or hedge fund should contain information similar to that of a prospectus for an IPO, as well as information regarding the general partner, special risks of investing in the product, and liquidity. You can also check with the Securities and Exchange Commission (SEC). There, you can obtain reports disclosing significant events (e.g., the CEO plans to sell a large amount of shares; an investor plans to purchase a large amount of shares for a takeover) and financial reports. One of the easiest ways to get information is to go to the SEC's website. This is some of the information that you can gather to help evaluate the risk of a particular investment.