Waddell & Reed

Understanding Risk

Risk is a fact of many aspects in life. It is often regarded as a negative, involving the possibility of loss, but it also can offer potential rewards and lead to a more fulfilling life. The key is to understand what risks you face and are willing to take. This applies especially to investment risk, and can take several forms. Following are some common types of investment risk that you should understand as you review your portfolio.

Market risk
All investment asset classes fluctuate, going up or down as they are influenced by market or economic factors. Fortunately, however, different asset classes don’t usually move in tandem. Therefore, if you diversify across various asset classes, such as stocks, bonds and cash equivalents, you may help ease the impact of a single market’s decline on your portfolio.

Currency risk
Investors who buy foreign stocks or mutual funds face the possibility that their investment returns may be reduced by a rising U.S. dollar. A declining dollar, on the other hand, may help increase the value of international holdings. Foreign investments also may be affected by different economic or political conditions in the respective country.

Credit risk
Fixed-income (bond) investors face the risk that the company issuing a bond will not be able to pay principal and interest in a timely manner. You can choose “higher-rated” bonds in an effort to help manage this risk, or you can choose a professionally managed mutual fund that invests in various types of bonds, meaning that one default may not impact the fund’s overall performance.

This graph is for illustrative purposes only and is not indicative of any investment. There is a wide spectrum of risk levels among asset classes. Risk is defined as fluctuations in returns from one period to the next. Lower-risk investments have averaged modest long-term historical returns. Higher-risk investments have averaged higher returns historically but with more volatility or fluctuations in value. Additional risks are associated with an investment in international and sector stock funds.

Interest rate risk
Rising interest rates can affect the stock market, but they particularly impact the bond markets, since the value of existing bonds generally declines when rates rise. Bonds with long maturities are especially vulnerable to this risk. Funds with varied maturities may help offset some risk.

Industry risk
Just as the broad market sometimes declines so do specific sectors within the market. These differing declines are generally due to developments in a particular industry. For example, technology stocks and products were in high demand in the mid- to late-1990s, but then crashed during the subsequent bear market. Stocks within an industry may move in tandem, so you may want to diversify your portfolio, potentially decreasing adverse effects from the decline of one sector.

As with your daily life, you will face some risk in your investment portfolio and in your long-term investment plan.

Diversification will not ensure a profit or guarantee against loss in a declining market. Please note that mutual funds will fluctuate in value and an investor can lose money by investing in mutual funds.

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