by Jana Swenson
In the investment arena, the concepts of risk and reward are inexorably linked; the greater the amount risk that an investor is willing to assume, the greater the potential for a higher return. Since different types of risk can impact the potential reward of different types of investments, it is important to understand how this may impact the investments in your portfolio and plan accordingly based on your own personal level of risk tolerance.
There is some degree of risk inherent in any investment.
In determining your own mix of investments and how you plan on balancing risk and potential reward, it is important to determine your willingness to take on investment risk in exchange for potentially higher returns, and your ability to stick with an investment through fluctuations in its value. There are a variety of factors that can impact the amount of risk that an investor may be willing to undertake, including:
- Age and investment time horizon
- Present financial condition (including assets, debts, liquidity, and responsibilities)
- Future financial goals
- Discretionary income and its variability
- Other particulars, such as taxes, transaction costs, historical performance, etc.
In addition to the issues listed above, it is also important to consider your emotional tolerance for risk. Many investors are more conservative or aggressive by nature, and it is important that you take on the amount of risk that you are most comfortable with assuming.
Diversification Can Reduce Risk – The concept of diversification can be simply explained by the old saying, “Don’t put all your eggs in one basket.” Basically, developing a diversified portfolio of investments and implementing differing investment strategies is the best way to reduce risk. By investing in different types of securities with different levels of risk and different types of investment strategies, you help insulate yourself from being adversely affected by market activity in any one security. Of course, diversification does not assure a profit and may not protect against loss.
Each investment you have in your portfolio will play a part in its overall performance. With diversification, gains in one investment may help offset losses in another. If you own several investments and one declines in value, its impact on your portfolio may not be severe.
Diversification may also allow you to protect yourself against the risk of outliving your money. If you don’t diversify into riskier assets like stocks and bonds, you run a substantial risk of retiring with a nest egg that is too small to generate the income you’ll need for a comfortable retirement. Inflation is an important factor in whether your retirement savings will last throughout your retirement years.
When considering diversification, remember that the whole is greater than the sum of its parts. And while diversification may cause you to sacrifice some of the upside potential, this should be more than offset by the benefits of a lower level of risk – a level of risk at which you are comfortable.
Jana Swenson is a Vice President/Investments with Stifel, Nicolaus & Company, Incorporated, member SIPC and New York Stock Exchange, and can be reached by calling the firm’s Murrieta, California office at (951) 461-7220 or toll-free at (866) 894-2461.