No investment is without risk. You may feel safe even when you do what financial advisers consider the “right thing” — invest in a broad stock market index fund with a long-term view — but there is risk there as well. Unfortunately, to build wealth over time, investors need to accept a significant amount of risk. Leaving money in risk-free investments such as high-yield savings accounts isn’t investing at all. By taking on very little risk, keeping the bulk of your wealth in a savings account practically guarantees you’ll lose purchasing power over the long term due to the rising costs of goods that you might buy with that money.
If you’re interested in growing your wealth over long periods of time — and most middle class investors will need to grow wealth rather than just preserve it if financial independence is an appealing goal — you’ll need to consider riskier investments than savings accounts. There is a dizzying selection of investment types ranging across the entire risk spectrum, from money market funds — low-risk investments similar to savings accounts — to complex financial derivatives — risky financial moves often best left to professional investors.
Anyone who has ever invested in a 401(k) plan has had the opportunity to be familiar with risk profiling. To help you design your retirement portfolio, most 401(k) managers allow you to select your investments based on your appetite for risk. By asking the investor several questions about how they would react to different levels of investment performance, these 401(k) tools will categorize the investor based on risk tolerance: usually low, medium, and high.
Measuring and evaluating the risk involved in any investment is a little more complex. While an investor’s risk tolerance can be categorized or marked on a scale, an investment’s risk should be plotted using several dimensions. To evaluate an investment, you should consider the different types of risk that could affect its performance in order to determine whether the investment is appropriate for you.
Market risk considers a broader picture. If you are invested in stocks, particularly if you choose the less expensive (but not necessarily safer) route of investing in a broad stock-based index fund, you have to accept that the overall economic condition of the country — or even the world — will cause your investment’s value to fluctuate. Market risk is relevant also for investments in single companies, bonds, or other products.
A market crash or decline could crush this investment’s performance, even if the quality of your investment remains the same. Investments also follow trends. For several decades, real estate could appear to be a “good” investment, encouraging more people to buy real estate, driving up prices for everyone else. Once the overall sentiment of investors switches to the belief that real estate is overpriced, your property could lose potential value even though the structure hasn’t changed.
Default risk is related to the quality of the underlying investment, and it is more apparent when investing in a single company, through stocks or bonds. If you invest in a company’s bond or a municipality’s, you generally expect a guaranteed return. The promised return is usually higher than what a savings account would provide, but you face the risk of default. If the company files for bankruptcy of if the municipality is mismanaged, it’s possible you won’t receive the return you were promised.
Pensions, thought to be stable investments for retirements, are also exposed to default risk. Today, your company may be promising all retirees access to free health care, but if your company later restructures, that promised benefit might disappear. The government offers a type of insurance for companies that offer pensions, but sometimes that insurance isn’t enough to ensure all pensioners receive exactly what had been promised.
Financial planners like to assume that inflation runs about 3 or 4 percent a year over long periods of time. This allows planners and investors to calculate expected “real” returns for an investment. If you assume inflation is 3 percent and your savings account earns 1 percent APY, your real return is a loss of 2 percent a year. This real return takes the effect of inflation into account.
There is a chance, however, that during any particular time, the measure of inflation — or for a more accurate description in this case, the increase of the cost of goods — is significantly more than 3 percent. If the country were to enter a period of hyperinflation, investments in your savings account until banks offer more appropriate interest rates would result in devastating losses when compared to consumer prices. When a gallon of milk costs $25, a gallon of gasoline costs $30, and a movie ticket costs $75, it will be much harder to get by on the same income you had with today’s prices.
Consider mortality risk when you have or are considering investments in pensions, insurance contracts, annuities, or any investment with a long-term horizon. Annuities are the best examples. If your annuity payments or distributions to you continue only as long as you’re alive, you run the risk of dying before you receive enough of your benefit to make the premium payments and fees worthwhile. If your investment strategy focuses solely on the long-term, there is a chance that you will never live to enjoy the benefits.
Life is short. It’s almost always shorter than you would want it to be. But mortality risk runs in the opposite direction as well. If you live longer than expected, and you have tried to plan your financial life so you fully expend your wealth during retirement, you run the risk of running out of money.
Spend some time to think about the risks of your investments. You may discover that your tolerance for risk is lower than you expected or that you’ll need to adjust to accepting more risk in order to meet your financial goals.