When it comes to the stock market, things can change—rapidly. Numerous factors impacting the value of individual stocks and the market as a whole can translate into being up one day, down the next. And try as they might, it can be near impossible for analysts to predict how the stock market will fare.
While the markets can be unpredictable, fluctuation is a sign that the stock market is working normally. As an investor, it’s important to get comfortable with the market’s volatility. Understanding how risk plays a role in investing can help inform the investing decisions you make for yourself.
Risk and Investing: What Does It Mean?
All investments come with risk. Unlike when you store your money in a savings account, investing has no guarantees that you’ll earn a return. When you invest, experiencing a financial loss is a possibility.
Different types of investments come with different levels of risk. Typically, as the risk increases, so do the potential returns. Understanding the types of risks associated with investing can be the key to informing your risk tolerance.
Types of Investment Risk
Just as there are a variety of investment vehicles, there are a number of different types of risk involved in investing. Here are a few common kinds:
Sometimes global economic trends, like a recession, or current events, like a natural disaster or political turmoil, can impact how the markets perform. Market risk refers to the potential for an investor to experience losses due to factors that are influencing the financial markets as a whole.
This type of risk is often referred to as systematic risk. The four most common types of market risk include interest rate, equity, commodity, and currency risk.
Interest rate risk reflects the market fluctuations that might occur after a change in interest rates is announced. Fixed-income investments, like bonds, are the investments that are most likely to be influenced by interest rate risk.
Equity risk refers specifically to the risk investors face from market volatility—the possibility that the value of shares will decrease.
Commodity risk comes from price fluctuations in commodities (raw materials) that impacts the users and producers of those same materials.
Currency risk is also known as exchange-rate risk. It stems from the price differences when comparing one currency to another. This type of risk is most relevant to investors who have assets in a foreign country or companies who have a lot of activities abroad.
Inflation measures the increase of the cost of goods over a set period of time and a rise in inflation means consumers have less purchasing power. Inflation risk is a concern for investors that have money saved in accounts with fixed interest rates, because the rate of inflation may outpace the fixed interest rate being earned.
When you buy a stock, you’re essentially buying a small share of the company. In order to make a possible return on your investment, the company you’ve invested in needs to remain in business. If a company goes out of business, common stockholders are likely the last to get paid, if at all.
This type of risk reflects the concern that investors won’t find a market for their holdings when they ultimately do decide to sell their investments. This could prevent investors from buying and selling assets as desired; they may have to sell for a lower price, if they are able to sell at all.
This risk could also apply to investments with strict term limits like a certificate of deposit (CD). Account holders would typically face a penalty from withdrawing or liquidating this account before the specified time.
In investing, a time horizon is the amount of time you have until a specific financial goal.
A lengthy time horizon could potentially allow you to take on riskier investments, since if you do suffer a loss, your investments will have more time to rebound.
Horizon risk occurs when the time horizon of an investment is unexpectedly shortened—like, say, by an unexpected, expensive medical emergency.
On the other side of the spectrum, investors in or nearing retirement could face the risk of outliving their savings. This is referred to as longevity risk.
This type of risk can occur when an investor is invested in a limited number of assets or owns assets only in one category or asset class. If that one category experiences losses, so will a concentrated investment portfolio.
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The Investment Risk Pyramid
Remember the food pyramid? Before MyPlate , the food pyramid was the gold standard of nutrition in the U.S. It recommended a hearty foundation of grains, followed by a smaller layer of fruits and veggies, followed by an even smaller layer of dairy, meats, beans, eggs, and nuts. At the very top, making up the smallest portion of the pyramid were fats, oils, and sweets.
The investment risk pyramid takes a similar approach, and could prove helpful if you’re looking for guidance as you’re evaluating the risks associated with different types of investments.
It may help you understand which investments pose the greatest risk, and can assist you in creating a portfolio that falls in line with your personal risk tolerance.
At the base of the pyramid are lower risk investments that have the potential to earn foreseeable returns. These investments create the foundation of a financial portfolio. Low risk investments typically include things like government bonds, CDs, money market accounts, and savings accounts.
In the middle of the pyramid are investments with moderate risk. These investments will be a little riskier than the base of the pyramid, but will hopefully lead to capital appreciation. Investments like high-income government bonds, real estate, equity mutual funds, and large and small cap stocks would fall into this category.
The riskiest investments are at the peak of the pyramid. Just like sweets, fats, and oils should make up a limited portion of your diet, these investments are generally recommended to only make up a relatively small portion of your overall investment portfolio.
Since these investments are so risky, some guidelines suggest only investing money that, if lost, won’t cause serious issues in your day-to-day life.
As you continue building your investment portfolio, it’s helpful to know that although the investment risk pyramid can be a useful tool, it’s just a guideline. Just as everyone’s dietary and nutritional needs are different, so are individual investment portfolios.Take it with a grain of salt.
Here’s the thing about investing—risk is an unavoidable reality. While you won’t be able to eliminate risk completely, there are strategies to help you manage the investment risks your portfolio is subject to.
Understanding Your Financial Goals and Risk Tolerance
The first step in managing risk will be determining your risk tolerance—how much risk you are willing to take on as an investor. Your financial goals could help inform your risk tolerance. Consider asking yourself what you want to use your money for and then figuring out the timeline for when you’ll need it.
The amount of time you have to invest will likely influence the type of investments you make with your money.
For example, if you are saving for retirement in 40 years, you may be able to take on more risk than someone who plans to retire, in say, 10 years.
Try as we might, we can’t plan for everything and life can change quickly. As it does, it can be helpful to re-check your financial goals and re-assess your risk tolerance to see if any changes are necessary.
For example, if you’ve recently had a child, you may want to integrate a college fund into your financial plan. Or perhaps you and your partner have decided you want to upgrade to a bigger house before growing your family.
Diversifying Your Portfolio
With a diversified portfolio, your money isn’t concentrated into one specific area. Instead, it’s spread across different asset classes—like stocks, bonds, and real estate—the money isn’t concentrated in one specific area within each asset class.
While it can be tempting to concentrate your investments into areas you are most familiar with, limiting yourself to only a few industries or types of investments can be the financial equivalent of putting all of your eggs in one basket.
A diversified portfolio can provide some insulation to risk. If your portfolio is highly concentrated in one area and that sector takes a dip, it’s likely your portfolio will be impacted.
But if your portfolio is balanced across varied assets and classes, the impact of one underperforming section won’t be felt as dramatically. While a diversified portfolio won’t eliminate risk, it could help make your portfolio a little less vulnerable.
You could choose to diversify your portfolio through a series of thoughtful investments. As an alternative, you could also choose to invest in mutual funds or ETFs—exchange-traded funds.
When you buy shares in a mutual fund, you are automatically invested in each company that is included in the fund, which provides instant diversification. ETFs, on the other hand, bundle a group of securities together in one neat package and they can be a low-cost way to diversify your portfolio.
Monitoring Your Investments
It can be tempting to set it and forget it when it comes to investments. But keeping an eye on your portfolio is another step that could potentially help you manage risk. You won’t know there is an issue unless you monitor progress.
As the market fluctuates, your portfolio likely will, too. Consider setting a recurring time to monitor your holdings. It doesn’t have to be every day, but once a week or even once a month could be a good idea.
How have the assets been performing? Is your portfolio still in line with your current risk preferences? If not, consider taking the time to make adjustments so you’re comfortable with where your investments stand.
Regularly checking in with your investments will also allow you to monitor your progress and see if you’re still on track with your goals.
Asking for Help
Investing can be confusing. Sometimes all it takes a second set of (experienced) eyes to provide a bit of clarity. Don’t feel like you have to build your investment portfolio in a vacuum.
Consider speaking with a financial advisor who can assist you in creating a personalized financial plan that is designed to help you achieve your specific goals.
Know that financial advisors often charge fees for their services, but they can often provide valuable insight and advice. SoFi members have access to one-on-one advice with certified financial professionals, at absolutely no cost.
Becoming an Investor
Now that you understand how risk impacts investments and some of the ways to manage risk, you might be ready to build your investment portfolio. Investing can be a good way to grow your wealth in the long term. And the good news is it’s never too early or too late.
If you’re ready to get started, consider an account with SoFi Invest®, which offers a variety of options so you can invest in line with your personal risk preferences and financial goals.
For those that like to be in the driver’s seat—there’s active investing. You can buy and sell stocks, creating a completely personalized portfolio without any fees.
Investors who prefer to take a less intensive approach can opt for an automated account. You won’t have to worry about tracking individual stock prices and making timely trades. The account will do most of the work for you, automatically rebalancing to stay in line with your specified risk preference.
And SoFi offers a range of exchange-traded funds. SoFi offers four different types of ETFs that are intelligently weighted and are automatically rebalanced, so they’re always at the forefront of growing industry.
Ready to start managing your investment risks? Learn more about ETF investing and how they can help you make the most of your investments.
Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.
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