When markets are more volatile than usual, as they have been this year, investors tend to look for ways to reduce risk in their portfolios. However, reacting to market fluctuations and global news by adjusting your portfolio may cause you to simply trade one risk for another.
Understanding risk matters because this knowledge can make you a better investor. There is no true way to eliminate risk entirely, but you can reduce it strategically with a clear understanding of what you’re up against.
Understanding the different types of market risks
As an investor, you face various risks by putting your money in the stock market. Balancing your portfolio through diversification can help mitigate potential adverse effects from these risks.
- Systematic Risk: the stock market rises and falls over time. You can reduce the risk of a decline negatively affecting your portfolio by reducing your exposure to stocks.
- Currency Risk: when you invest in international markets, remember that changes in the currency exchange rate may affect your investment returns.
- Geopolitical Risk: international investments can also sometimes be unstable due to events such as war, new or updated laws, or leadership changes.
- Liquidity Risk: some investments are illiquid, or not easily converted to cash, which can be a problem if you need immediate access to your funds.
It may be tempting to chase better returns or put all your eggs in one basket. However, building a diversified portfolio and holding your positions over a long time horizon can help you achieve steady growth that meets your financial needs.
Understanding the different types of savings risks
Fixed income, also known as bonds or cash, refers to financial vehicles that pay you periodic interest payments over time. Government bonds and bank savings accounts are often mistaken as being “safer” than investing, but they carry their own types of risks.
- Inflation Risk: the annual inflation rate for the United States is a record high of 7.9%. If your savings interest rate is lower than this, your buying power will decrease.
- Interest Rate Risk: interest rates rise as bond prices fall. If the interest rate changes after you buy a bond, your purchased bond may then be worth less than before.
- Reinvestment Risk: people often reinvest matured bonds into another bond, but this reinvestment may be at a lower interest rate, which reduces your income.
- Default or Credit Risk: remember that with fixed income, you are essentially giving the issuer a loan. There is always a chance the issuer will not be able to make payments.
Relying on fixed income often reduces your buying power over time and prevents you from achieving the steady growth you need to meet your goals.
Understanding the different types of investment environments
Besides understanding the various types of risks, you should also understand how these risks may affect you differently depending on your investment environment.
When you are in the accumulation phase, you are working on building up assets for retirement. The accumulation investment environment has three stages:
- Early: in this stage, you are just starting to build up assets for retirement. You may have just gotten a new job or taken on debts such as college loans or a mortgage. During this time, you may want to stay more liquid rather than aiming for higher returns.
- Mid: in this stage, you are most likely more secure in your career and may not need quick access to liquid funds anymore, but still have 10-15 years until retirement. During this time, you can take on more market risks to achieve higher returns.
- Late: in this stage, you are closer to retirement. While you can still save more, as in the mid-accumulation stage, you may want to lower your risk allocation and introduce more cash and fixed income to reduce exposure to significant risk and volatility.
Adjusting your portfolio according to these stages rather than reacting to market fluctuations and global events can help you meet your financial goals while taking on an appropriate level of risk.
When you are in the distribution phase, you are no longer working for your income. Instead, you may be starting to withdraw money from various accounts.
If you have a significant pension plan that can take over half of the income needs for your household during retirement, you may want to continue a slightly more aggressive investment portfolio. This strategy will help you continue to grow your wealth, even as you withdraw from your pension, 401(k), Social Security, and other accounts.
If you have lower savings or higher income needs, you may want to be more conservative in your investment portfolio. This strategy will prevent you from running out of funds as you enjoy the results of your hard work over the years.
How to reduce risk strategically
Now that you are more familiar with the various types of risks and investment environments, how can you use this knowledge to reduce risk strategically? Two essential steps include diversifying your portfolio and developing a financial plan with purpose.
Diversifying your investment portfolio reduces the negative impact of any downswings in a particular area of your portfolio. Concentrating your asset allocation in a single stock or sector is not recommended.
Investment diversification is possible within the U.S. market alone, but global diversification allows you to benefit from even more growth opportunities. Learn more about why you should include international markets in your investment plan.
Financial planning with purpose
Investing simply for the sake of investing is not ideal because it leaves you without a clear direction or purpose. Defining why you’re investing can help you determine your risk tolerance, understand your time horizon, and choose investment vehicles that align with your financial plan and values.
For example, let’s say your portfolio is at 70% allocation, but is on track to cover your needs at retirement. In this case, there is no need to take on more risk and aim for 100% allocation. Holding your diversified, cost-effective position over your time horizon will help you achieve the gains you need.
Your personalized investment plan should be designed to work best for you and your goals. Talk to your Oakwell team to learn more about investment strategies to reduce risk and grow your wealth in today’s market.