Weighing risks and rewards is important for decision making. It’s true for buying a home or changing careers. It's also true for investing. Knowing some of the risk factors and how to manage them may help you make better investment choices.
Take Smart Risks
All investing involves risk. Taking on risk can be scary, but it might also help you get the returns you need to reach your goals. How much risk could you take, theoretically? And how much are you willing to take, realistically? As you consider your answers, consider your time and tolerance.
Time: How Much Time Do You Have?
The longer you have to invest, the more risk you can likely take because your investments have time to recover from market drops.
Generally, the closer you are to your goals, the less risk you’ll want to take.
Tolerance: How Does Risk Make You Feel?
Knowing your willingness to take risks can help you choose investments that fit you. However, also consider:
• Taking as little risk as possible may prevent you from reaching your goals.
• Choosing riskier investments to compensate for a lack of savings could put your investments in a precarious position.
Find Your Risk Comfort Zone
To find your comfort level with risk, consider your reaction to a steep market decline.
If the value of your investments suddenly dropped by 20%, what would you do?
Sell everything or move to a money market fund.
Your risk tolerance is likely lower, and you may want to consider more conservative investments.
Wait and see if the market rebounds, or buy more securities because their prices are lower.
Your tolerance is likely higher, and you may be able to handle riskier investments.
How you answer can give you a good idea about your risk tolerance. It can also help you decide what kinds of investments to include in your portfolio and how much of each.
Understand Investing Risks
Not all investments carry the same risks. Below are some to consider, as well as potential ways to manage them in your investment portfolio.
What to Do
Economic events can cause the value of your investments to drop. Market declines can be spurred by anything from political events to weather—events that cause investors to be wary.
Include a mix of investment types that react in different ways when markets change. When one area of the market is not performing well, it may be offset by others that are.
💡 Be sure to stick with your plan. A long-term outlook reduces the temptation to buy or sell based on emotion or short-term events.
Inflation—the increase in the prices of goods and services—can erode your purchasing power if your investments can’t keep pace. Over the past 20 years, inflation has averaged about 2.05%.1
Strategy: Add Investment Risk
You may need to take on some additional investment risk to get returns that will outpace inflation. Note that riskier investments can mean higher highs, but also lower lows.
💡 You can also hedge against rising prices with investments that are specifically designed to protect against inflation.
Changes in interest rates affect bond investments. Higher interest rates usually mean lower bond prices, and vice versa.
Strategy: Choose a Shorter Duration
A bond’s duration measures its price sensitivity to changes in interest rates. Shorter duration bonds are usually less volatile when interest rates rise. The longer the duration, the more the bond’s price will change.
💡 Corporate bonds and mortgage-backed bonds* are generally less sensitive to interest rate changes than other types of securities.
Investing in bonds comes with the possibility that the bond issuer will fail to repay the loan. Credit ratings reflect an issuer’s financial strength and ability to make timely interest payments.
Strategy: Look for Quality
Higher credit quality can help minimize your risk. Investment-grade bonds have less risk of issuer default but also lower yield potential (rate of return). They have credit quality ratings of BBB or higher.
💡 While high-yield bonds carry a higher risk of default, they have more yield and return potential. High-yield bonds have credit-quality ratings of BB or lower.
Source: Consumer Price Index, Bloomberg, American Century Investments. Data from March 2001 to March 2021.
This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
Diversification does not assure a profit nor does it protect against loss of principal.
Generally, as interest rates rise, the value of the securities held in the fund will decline. The opposite is true when interest rates decline.
Credit letter ratings indicate the credit worthiness of the underlying bonds in the portfolio and generally range from AAA (highest) to D (lowest).