Risk is all around us – we know that. We are seeing the effects of it right now as the markets continue to roil! But history has shown us that successful long-term investing requires discipline and patience. When emotions and investment risks run high, it can be easy to lose focus on your long-term strategy. To help understand the risks investors face, here are a few important items to keep in mind:
Do You Know the Risks?
Markets can be turbulent! We have seen it before, and we will see it again in the future. There can be a strong temptation to abandon your plan when times become volatile. However, by understanding the risks investors face, it may be smarter to adjust, other than abandon your investment approach. By remaining flexible, you might be able to take advantage of opportunities while still managing risks. To do so, you must understand what you are facing.
- Interest Rate Risk is the potential for investment losses resulting from a change in interest rates. If interest rates rise, for instance, the value of a bond or other fixed-income investment may decline. We are seeing this right now with the activity being taken by the Federal Reserve in accelerating the rise in the Fed Funds Rate at a pace we have never seen before.
- Market Risk is the risk that arises from movements in stock prices, interest rates that companies must pay for credit, exchange rates, and commodity prices. As the demand and supply of goods and services change, market risk is either intensified or reduced based on the many factors driving our domestic or global economy.
- Credit Risk is the risk of loss from the failure of a counterparty to make a promised payment. Lenders and bond holders face this risk which is reflected in the valuations of the transactions they are involved in. This risk is then passed down to investors through the value of the underlying debt instruments they may hold in their portfolio.
- Currency Risk, sometimes referred to as “exchange rate risk”, arises from the change in the price of one currency in relation to another. Investors or companies that have assets or business operations across national borders are exposed to currency risks that may create unpredictability.
A Risky Balance
A variety of factors may cause investors to act more cautiously than normal, including ongoing global uncertainties and fears about the overall economy. We are seeing this play out before us right now. This often leads to investors flocking to what is perceived as low-risk investments despite the long-term misalignment with their goals. Remember, while minimizing risk can feel like a safe move in the short run, you may miss out on opportunities over time as a result.
Another mistake can be creating a portfolio that doesn’t reflect your overall risk tolerance. When building a portfolio, the objective is to take on the amount of risk that aligns with your goals and time horizon. This is often accomplished through a diversified allocation of assets that may help manage your portfolio’s risk. It’s important to remember that asset allocation is an approach to help manage investment risk, not eliminate it. It offers no guaranteed protection against investment loss.
The rates displayed are hypothetical in nature and for illustrative purposes only. They do not represent any specific account or strategy. The actual rates of return for your specific investments may vary. Indexes are unmanaged and not available for direct investment.
The graph above (Returns Web), shows the growth of $1 in the S&P 500 over the last 95 years. As you can see, the U.S. domestic market has faced many different types and periods of risk throughout history. We know that no one can predict the future based on events of the past; but history does demonstrate that “Time in the Market” has helped mitigate the effects of risk over the long term. It’s impossible to time the market in the short-term, so that is why we believe that it is so important to have a financial plan, be diversified and allocated correctly based on your risk tolerance and goals. Do not make impulse decisions based on emotions and current events.
Leave Emotion at the Door
When markets swing, emotional decision making can wreak havoc on the most carefully designed investment strategies and financial plans.
Fear and greed can drive financial decisions. Fear can cause us to abandon an investment strategy when the outcome is not what we want, while greed can cause us to chase investment fads and assume too much risk. Working with a seasoned financial professional may help you manage these emotion-based decisions. An investment professional may be able to help when emotions enter the decision-making process. When markets decline, they can answer questions, provide reassurance, and show you the opportunities that volatile markets, and RISK, may provide.