Find the Right Balance Between Risk and Reward
With any decision you make in life, you need to decide if potential rewards offset any risks. It's true for buying a home or changing careers. It's no different with investing—you need to consider the potential that your investments could lose value as share prices fluctuate.
Once you understand the risk factors, one way you can help lower your overall risk is to spread out, or diversify, your investments with mutual funds. Diversification can help even out price swings during times of market volatility.
Understand Market Risks
Two long-term risks to your investments can be market cycles and inflation. When you understand how either may affect your portfolio it can help you make better investment decisions.
The stock market is like a pendulum, swinging between highs and lows. You need to decide how much of these ups and downs you can handle. Natural corrections will occur, such as when earnings are overinflated. The important thing is not to become discouraged during market lows or overly optimistic during market highs. Taking a long-term outlook is the best approach. Otherwise, you might be tempted to buy or sell investments based on emotion or short-term market events instead of careful planning and strategy. The key is to identify and understand this risk, then pursue a strategy that will help you get rewarded for the risks you take.
Another long-term risk to your goals may be that your investment return won't keep pace with inflation. Over the past 30 years, inflation has averaged about 2.8% annually.1 To outpace inflation you may need to be willing to take on some investment risk to achieve returns that will help you reach your goals.
Find Your Risk Tolerance Comfort Zone
To find out your comfort level with risk, consider how would you react if the stock market declined and the value of your investments suddenly dropped by 20%? Would you:
- Sell everything?
- Move to a money market fund?
- Wait and see if the market rebounds?
- Buy more securities because their prices are lower?
How you answer can give you a good idea about your comfort level with risk. It can also help you decide what kinds of investments your portfolio should include (how they should be allocated).
You can learn more about your comfort with risk and review investments that fit different levels of risk by using our interactive Investment Planner tool.
Build a Rewarding Portfolio
A well-balanced portfolio should include investments that give you the right amount of risk and reward to reach your goals. The idea is to select investments that react differently to market conditions so that a gain in one market could offset a decline in another, thereby reducing the risk to your overall portfolio.
When you spread your investments among stock, bond and money market funds, you can lower your overall investment risk and ride out market ups and downs. Each type of mutual fund offers a specific benefit for your portfolio.
Each Kind of Mutual Fund Can Benefit Your Portfolio
Stock Funds Can Add Potential Growth
Investing in stock funds lets you participate in the growth of multiple companies and the economy in general. You receive the benefit of professional portfolio fund management without the sometimes difficult process of choosing individual stocks. Stock funds are further categorized by investment style (growth, aggressive growth, value and index), country and sector.
Bond Funds Can Provide Income and Stability
Many investors include bond funds in their portfolios because they are considered more stable than stock funds. Bonds are essentially loans from you to issuers, such as governments, agencies or corporations. These entities agree to pay you back with interest during a certain time frame. Two important things to consider are the issuers and taxes.
Money Market Funds Seek Capital Preservation
These funds may be suitable if you need relatively easy access to cash, such as through check-writing privileges. Historically, they have provided returns comparable to bank certificates of deposit or savings accounts and can add stability to your portfolio. Money market funds hold securities such as U.S. Treasury bills that mature in less than a year.
A Pre-Diversified Alternative May Be the Right Solution
While many investors like the opportunity to build their own portfolio, a convenient solution for a balanced portfolio is an asset allocation fund. Sometimes referred to as fund-of-funds, these are ready-made portfolios already diversified among stock, bond and money market funds. An asset allocation fund can provide your portfolio exposure to more securities by spreading your investments across a number of funds.
Asset allocation funds can be either risk based or based on your investment timeframe, offering several choices to fit your level of comfort with risk. The professional money managers take care portfolio construction, active management and periodic rebalancing.
1 Source: Bureau of Labor Statistics, 2014
Diversification does not assure a profit nor does it protect against loss of principal.