Everyone wants to make informed financial decisions that will help them build wealth and provide a more secure future over time. But an uncomfortable reality remains: investing money assumes a certain degree of risk, no matter what kind of investments you choose.
Some risks are low, while others are high—but don’t let the fear of assumed risk keep you from investing your money entirely. Countless people have benefitted from investing wisely and strategically. Knowing the potential risks can help you avoid common pitfalls and position yourself up for success.
3 Common Types of Risk Investors Face
1. Market Risk
The economy fluctuates throughout the year, and the market rises and falls in a similar manner. Stock investments can also rise and fall in the near term, so your shares may not provide their long-run projected return over the short-term.
Bond investments can decline as interest rates change. There’s no way to avoid market risk entirely, but financial advisors can provide mitigation strategies that can help.
2. Inflation Risk
The market does not always keep up with inflation. Over time, the rising prices inflation causes could outpace your rate of return, which reduces your purchasing power.
Typically, inflation can affect fixed-income securities more than stocks since most bonds come with a fixed interest payments. Finding the right balance between stocks and bonds in an investment portfolio is one consideration financial advisors can help you assess.
3. Concentration Risk
When a particular security seems promising, you may want to pour a large percentage of your money into it. A concentrated position is much more susceptible to fluctuation risk. The market is unpredictable, and individual securities or industries could face unforeseen situations that can strongly affect a single holding. A diverse portfolio is generally a more prudent strategy.
Every situation is different, but many professionals will advise against this strategy. Concentration risk is avoided by diversifying your portfolio. A diverse portfolio is generally a more prudent strategy.
How to Manage Risk
While risk cannot be avoided entirely, you can manage it. Many investors choose low-risk investments, which typically provide a reasonable return over time, even if growth is slow and steady. High-risk investments offer the potential for impressive gains, but they also bring the potential for significant fluctuations in gains or losses.
Everyone is looking for safe investments with high returns, but “safety” is a relative term. The variation between high and low risks is less like two specific categories and more like a continuum.
To build a financial portfolio that works for you, you must determine your own risk tolerance. Generally speaking, a diversified portfolio includes a mix of high and low-risk securities, but your financial advisor will help you select specific options based on your risk tolerance and investment objectives.
Avoiding Risk vs. Reducing Risk
Informed investors know that they can’t avoid risk completely, but they can reduce it. Risk avoidance does not mean refusing to invest money and leaving it in a savings account to accrue with relatively low interest. It can include other types of investments with an aim toward risk reduction. For example, you can reduce investment risk by building a diverse portfolio, researching stocks, fixed income, and mutual funds thoroughly, and minimizing unnecessary unsystematic risk.
Systematic Risk vs. Unsystematic Risk
The market is built on a foundation of ebbs and flows. Economic turns, political shifts, and other national and global factors cause market fluctuation. When you invest in the market, you’re embracing systematic risk: unpredictable ups and downs that affect every type of security. Informed investors know that systematic risk is a part of the equation—and that it’s not intrinsically problematic.
On the other hand, unsystematic risk arises from specific industries or companies. Not every investment experiences unsystematic risk. For example, if you invest solely in securities associated with a financially volatile industry, you may experience unprecedented gain—or unprecedented loss. Unsystematic risk is a personal decision, and your financial advisor can help you decide if it’s an appropriate choice for your situation.
Risk Management Tools
As you evaluate your potential risks and returns, you can check several equations that will aid your investing decisions.
- Standard deviation: This equation helps investors determine relative risk. The higher the calculated standard deviation, the more volatile the expected returns should be.
- Sharpe ratio: This ratio compares a security’s risk with its return. A ratio of greater than 1 is generally considered to be favorable since it implies the investment should offer excess returns relative to its volatility.
- Beta: This equation compares the volatility of a particular security to the market. A Beta higher than 1 implies the investment is more volatile than the market, while a Beta less than 1 implies less volatility than the market.
These data points, and other helpful tools, are often listed on financial websites. Your financial advisor can help you interpret them further. Researching your investment options according to these numbers can help you build a portfolio with the power to better withstand market fluctuations over time.
Personalized Investment Support
The market can be complex and confusing, but you don’t have to navigate it alone. At Marietta Wealth, our team of experienced and knowledgeable investment management advisors is here to help.
When you work with us, you’ll find a financial partner who seeks to understand your current financial situation and your preferred outcomes. We’ll help develop an investment strategy based on your investment return expectations, time horizon, and risk tolerance. Begin creating your investment plan with Marietta Wealth today.
The information provided is for informational purposes only. It is not intended to be used, and should not be used, as the sole basis for legal and/or tax advice. Individuals should seek and rely upon the guidance and advice of their own legal and tax counsel before making any decisions regarding any planning, investment, tax concepts or strategies discussed herein. Individual circumstances may vary and results discussed are no guarantees of applicability or future performance.
Marietta Wealth is a registered investment adviser. Registration of an investment adviser does not imply any level of skill or training. For additional information about Marietta Wealth’s financial planning and advisory services, please see the Marietta Wealth Disclosure Brochure or ADV Part 2A for full details, which is available upon request or by visiting our website.