Many years ago when I started investing, I was terrified of risk. Tales of the Great Depression and people jumping out of buildings during the stock market crash of 1929 floated in my mind.
Fast-forward several decades. After investing many dollars, I have learned how to understand and manage risk in investing.
Sensible investing in the financial markets is important to grow your money for the future. You need to earn the type of returns that will allow you to spread out earnings over a long life. That is difficult to do until you identify the parameters of risk and understand your individual risk tolerance.
Types of Investment Risk
You cannot avoid risk, but you can learn how to invest so that you will minimize risk while maximizing returns. There are three principal types of investment risk:
1. Loss of principal: This involves losing a portion of — or even all of — the money you originally invested. For instance, let’s say you buy 100 shares of stock for $10 per share, for a total cost of $1,000. Six months later, the value of your stock drops to $9 per share and your total investment falls to $900.
If you choose to sell your shares at this point, you have lost $100 of your principal. Of course, fees and commissions could increase your losses.
2. Loss of purchasing power: Purchasing power is the real-world value of a sum of money to buy things such as products and services. A loss of purchasing power means that same sum of money no longer buys as much as it once did.
For example, let’s say you invest $1,000 in a five-year certificate of deposit paying 2 percent interest per year compounded monthly. At the end of five years, your $1,000 is worth $1,105.08.
Sounds like you made money, right? Well, not if you look at things in terms of the current purchasing power of your cash.
If inflation is 3 percent per year, you will lose money — “purchasing power” — with this CD because your 2 percent annual return is less than the 3 percent annual inflation rate. Five years of 3 percent annual inflation means it will take $1,159.27 to buy $1,000 worth of goods. Meanwhile, you have only earned $1,105.08 on your “safe” CD.
3. Risk of outliving your assets: If you choose to invest solely in low-return “safe” investments such as CDs and government bonds, you run the risk of outliving your money. Imagine this scenario: You save $6,000 diligently every year from age 30 to age 65. Here is what you will earn at various rates of return at the end of that period:
Save $6,000 per Year for 35 Years
Annual Amount Invested
Annual Rate of Return
|$6,000||3%||$373,656||Short-term bonds and savings accounts|
|$6,000||5%||$569,018||Corporate, government and mid-term bonds|
|$6,000||7%||$887,481||U.S. and international stocks|
If you are too risk-averse and only put your money in low-return investments, you run the risk of outliving your money.
What Is Your Risk Tolerance?
Risk tolerance is a tricky concept to measure. You might think that you can handle a 20 percent drop in your retirement account. Yet when faced with an actual market crash, you might overreact and sell. That locks in your losses.
But while risk-tolerance questionnaires are imprecise — and might not indicate how you would feel in a real-life situation — they are the best tools available for now. Based on how you answer a few questions, a risk-tolerance quiz might categorize you as a:
- Conservative investor
- Moderately aggressive investor
- Aggressive investor
After you understand your risk tolerance, you are better equipped to find the right investment mix for retirement and other long-term goals.
How to Invest Your Money When You Are Risk-Averse
If you are a risk-averse investor, you probably want to dial back on the risk in your portfolio. Some key tips for investing with this frame of mind include the following.
Stephanie Genkin, a New York-based certified financial planner, recommended risk-averse investors maintain an asset allocation that allows them to diversify. For long-term investors, Genkin recommended investing 60 percent of a portfolio in stock index funds and 40 percent in bond index funds.
Genkin also warned against trying to time the market by jumping in and out of investments in hopes of increasing returns and avoiding losses.
Timothy Baker, a CFP and CEO of WealthShape, guards against country-specific risk by urging clients to expand their investments to include international stock funds. And to quell portfolio volatility, he suggested investing in high-quality, diversified, short-term bond funds.
Use Dollar-Cost Averaging
If you are working and earn a steady paycheck, dollar-cost averaging can be a very effective way to invest, Genkin said. As part of this strategy, you decide on a fixed amount of money to automatically invest in a variety of funds on a set date every month. When the date arrives, you buy however many shares your money will purchase.
“When the market drops, your money will buy more shares,” she said. “When the market is high, you will buy fewer shares because they’re more expensive.”
Consider a MyRA
The U.S. Department of Treasury’s myRA investment option might make sense if you are risk-averse, said Jamie Hopkins, a retirement income certified professional, professor of taxation at The American College in Bryn Mawr, Pa., and co-director of the New York Life Center for Retirement Income.
Hopkins said myRA comes with one investment choice, a government security that guarantees your original investment and grants returns that will keep pace with inflation. For the 2015 tax year, you can invest in a myRA until April 15, 2016, as long as you meet the Roth IRA eligibility guidelines.
Purchase Individual Bonds and Bond Funds
Bonds are widely considered a good investment for the risk-averse. Historically, bonds are less volatile than stock investments. From 2006 through 2015, the 10-year Treasury bond — a proxy for bond returns — rewarded investors with a 4.71 percent average return. This average return will earn you a small premium over the historical inflation rate.
Short- and medium-term bond funds are sensible for a rising interest rate environment. One such fund, the Vanguard Intermediate-Term Bond Index Fund Investor Shares (VBIIX), has an attractive 0.2 percent expense ratio.
The 1% Don't Want You to Know About These 5 Investments
Five investing strategies the wealthy use that you should consider right now
Rochelle Odesser, a CFP and vice president with Madison Planning in White Plains, N.Y., has many risk-averse clients. For investors with a lot of assets, she suggested buying individual corporate or municipal bonds. Odesser likes individual bonds because they reward the investor with an income stream and return of the principal value of the bond when it matures.
Jim Wright, a chartered financial analyst and chief investment officer of Harvest Financial Partners in Paoli, Pa., suggested a bond ladder for risk-averse investors. He urged investors to purchase individual bonds that mature each year for the next five to seven years.
“You can choose to extend the bond ladder for a longer period or a shorter one, but our preference is five to seven years,” he said. “By building a bond ladder, you have cash flow coming in to your portfolio each year.” As interest rates rise, you can enjoy higher returns as you reinvest proceeds.
Stick to Blue-Chip, High-Dividend Stocks and Funds
Odesser also recommended dividend-paying stocks for her risk-averse clients. Well-known companies with robust dividends include Exxon Mobil (XOM), which recently sported a 3.76 percent yield; and General Electric (GE), which recently had a 3.02 percent yield.
Mutual funds and exchange-traded funds that invest in dividend-paying stocks can broaden diversification and put a damper on volatility. The SPDR S&P Dividend ETF (SDY) and the S&P High-Yield Dividend Aristocrats Fund (SPHYDA) each track the S&P High Yield Dividend Aristocrats Index, which includes the stock of companies with a long-term record of increasing their dividend payments.
It is important for investors to recognize that individual stock and stock fund values might go up and down, and companies can also cut dividends in addition to raising them.
Weigh Whether to Purchase an Annuity
Although not technically an investment, the annuity insurance product might fit the bill for the risk-averse investor. The qualified longevity annuity contract (QLAC), a newer offering, is available inside of 401(k)s and IRAs.
Hopkins says the QLAC has several benefits, including a good return, guaranteed income and the possibility of improving your retirement security. Just make sure to investigate fees when considering annuity products.
Remember that in investing — as in life — some risk is unavoidable. Tilt your investing toward more bonds and fixed assets for less volatility in investing.