Understanding and Managing Risk

Mention the word “risk” in the context of a discussion about investing and what springs to most people’s minds? A huge loss when the stock market takes a dive? Or when the price of bonds tumbles? Most likely. Such possibilities lead some people to cling to the “safety” of cash equivalents that bring no risk to their principal. These investors fail to recognize that risks are inherent in this kind of savings, too.

The truth is, all investing involves risk. But risk shouldn’t keep anyone from investing. Successful investors learn how to manage their risk by finding a comfortable balance between the risks that they are willing to take and the rewards commensurate with those risks.

Stock risks
Historically, stocks have offered investors the highest long-term total returns. According to Morningstar, Inc., large company stocks, as measured by the S&P 500’s total returns from the beginning of 1926 to 2006, produced a compound annual growth rate of 10.42%—and 15.8% in 2006.*

Of course, there can be bumps in the road. For example, for the period 2000 through 2002, large company stocks produced negative returns. Obviously, then, because stocks can give you a roller- coaster ride at times, you can’t depend upon them more than you can comfortably afford to.
What kinds of risk do investors in equities face?

• Company and industry risk. If the company issuing the stock fares badly, or is held in low regard for some reason, the price is likely to fall. And a falloff in business in an industry can affect the price of a company’s shares, even if the company itself is not faring that badly.
• Market risk. Certain factors may cause the market as a whole to move. They may be economic—for example, expected or reported rises or falls in economic growth—or national or international events. Of course, factors that can depress a stock’s price may have a flip side—good news can send the market, as well as the investor’s equity holdings, upward.
• Liquidity risk. There is always the danger with any investment of not being able to get out of the investment conveniently, at a reasonable price. When forced to sell a holding suddenly, an investor could suffer a significant loss. (This risk is not limited to stocks alone.)

Bond risks
Bonds generally are perceived as a lower-risk investment than stocks. When bonds are held to maturity, bondholders should receive back their principal, in addition to the income earned on the bonds.

• Default risk. Here’s why we said “generally”: It’s possible that a company or other bond issuer will fail to make payments on its debt and not pay the bondholder back all or part of his or her principal.
• Credit risk. Bondholders must deal with the possibility that the issuer may not meet the scheduled income payments or return principal on time.
• Interest-rate risk. Bond prices are sensitive to changing market conditions. When interest rates rise, bond values fall. Therefore, when new bonds pay more income than bonds that an investor already owns, the risk arises that if the investor has to sell the bonds, he or she may have to do so for less than what was paid.

 

Cash equivalents risks
“Cash equivalents” refers to short-term investments whose value fluctuates only modestly with changes in prevailing interest rates. As mentioned earlier, some people think of these investments—CDs and money market funds, for example—as “risk free.” However, that’s not entirely true. Inflation can be a factor here, too. A sneaky thing about inflation is that you’re usually comparing your purchases in short time periods—weeks or months. It’s when you look at years of inflation that you begin to understand fully how damaging it can be to what you’ve earned and saved over the years.

A return on your investments that doesn’t at least match inflation means that you’re not gaining, you’re losing. Only if your investment return surpasses inflation can you expect to be gaining ground.

Managing risk
The first step in risk management is to determine how much risk you can live with—and stick with. Many factors will contribute to your decisions about how much risk to take: Your age, your knowledge of investments, your attitude toward risk are just a few of them.

If you know your comfort level, you can take the necessary actions to manage the risks that you are willing to accept. For instance, developing an asset allocation strategy and diversifying your investment capital among a mix of stocks, bonds and cash equivalents are important steps in the process.

To find the right level of risk is every investor’s challenge, but one that needn’t be faced alone. Calling upon the knowledge and experience of our professionals to assist you will help you meet that challenge.

*Indexes are unmanaged. Investors cannot invest directly in any index. Past performance does not guarantee future results.

© 2007 M.A. Co. All rights reserved.