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How Understanding Risk is Key to Investing

Understanding the risks of your investment choices is a key element in financial planning. Risk is not limited to how much one might lose in the markets. That's only downside risk. Risk also includes opportunity cost or upside risk. While most investors think of an investment's risk in relation to how much they might lose if it goes down after they buy it, upside risk is how much an investor might miss out on if the markets go up and they're not invested. 

Balancing Risk

Balancing the two types of risks is crucial to being a successful long-term investor. The amount of risk deemed appropriate is not the same for each investor though. Age, job stability, health, short-term and long-term goals, among others, factor in to how much upside and downside risk should be accepted per individual investor. Figuring out the appropriate risk is a major step, but not the end of deciding how to allocate funds. Investors need to factor in how they react emotionally to big swings in the markets too. For example, an investor may tend to sell in a panic when stocks enter a bear market. Instead, they could be more conservative overall, and while they might give up potential gains on the upside, this could lead to smarter decisions for their investments than selling after stocks have lost more than 20% and before they have a chance to recover. (For more, see: Trying to Beat the Market? Consider These Steps Instead.)

Investors who are very risk averse might buy U.S. Treasury bills (aka T-bills), often considered a risk-free investment as they offer the safest interest rate of all financial instruments. Those investors might not lose any money in their eyes, but when inflation and opportunity costs are factored in, the losses can be big over time in real dollars. While T-bills can be a good part of an overall portfolio, accepting a little more downside risk tends to reduce upside risk considerably and can significantly improve long-term gains.

Without delving deep into the historical returns of each asset class, just consider what a small increase in the rate of return can do to an initial investment of $10,000. Over a 30-year period a $10,000 tax-deferred investment that gains 4% annually will be worth $32,433.98 (a 324% total gain). A 6% return moves the value after 30 years up to $57,434.91 (a 574% gain) and an 8% return brings the initial investment up to $100,626.57 (a 1,006% gain). Notice that the 8% gain, while double the annual percentage gain, is worth more than three times as much after 30 years due to compounded interest.

A Common Mistake

A common mistake by those nearing retirement is moving too much of their retirement portfolio into what has been labeled "safe." These "safe" investment vehicles typically only refer to downside risk, but to be truly safe in the long run a portfolio should be balanced for an opportunity to grow also. If someone retires at age 60 and lives another 30-40 years, the risk of their "safe" investment might be that they run out of money before they are finished spending and that's without even adding in the additional risks of inflation. Consider all types of risk when planning your own asset allocation or discussing long-term plans with your investment advisor. It's never too early to plan for retirement. (For more, see: Why Investing Doesn't Have to Be Confusing.)