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Investment risk is the possibility that due to volatility in market prices
your capital will lose value and may be worth less than you originally
invested. Many investors hope to make a lot of money with very little
risk to their principal, but there is an inverse relationship between
risk and return. Without price fluctuation (volatility) capital will not
have the chance to grow. Most investments fluctuate 50 percent in value
over the short term. Some principal volatility is normal in a sound investment
plan. An experienced investor won't panic when prices drop, but will consider
what the investment has done over three-, five-, and ten-year periods.
Any investment involves some risk. But if you have educated yourself
to be able to recognize and evaluate the risks you may encounter, you
will be better able to balance your investment objectives and tolerance
for risk.
The risks you must be concerned with are:
- Market
risk. The price of stock may fall, an industry may decline, the
company may go out of business, and weather or political conditions
may cause you to lose part or all of your investment. Never invest more
than you are prepared to lose.
- Interest rate risk. There
is usually an inverse relationship between bond and stock prices and
interest rates. When interest rates rise, stock prices usually fall
whereas bond prices will rise. Some investments such as CDs and bonds
have a fixed rate of return. This can be to your benefit if interest
rates fall but to your disadvantage if rates rise.
- Inflation risk. Although
it has been low in the past few years, it would be a mistake to underestimate
the impact inflation can have on investments over time. Gold, art, real
estate, and other equities have done well in times of high inflation.
During times of low inflation these investments are not likely to outperform
safer investments such as CDs. The loss of purchasing power due to inflation
is much harder to measure than a drop in the price of a stock.
- Liquidity risk. Widely
traded stocks and mutual funds are easy to sell. Limited partnerships
and art collections are more difficult.
If you are investing in a mutual fund, does your risk tolerance match the
fund's risk level? Studies have shown that men tend to take higher risks
when investing and want short-term results. Women tend to approach investing
for the long-term and are more patient. And that's what counts for building
retirement savings.
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