Risk Can Be a Good Thing Under the Right Circumstances

The payoff for a successful investment may be plentiful, but the underlying risks aren't always as obvious. In fact, there are several different types of risks for investors to consider, based on the allocation of assets in your portfolio. Understanding and calculating the risk of an investment before deciding to either go ahead, or choose another path, is the difference between strategy and rash behavior.

Here is a brief overview of six of the risks in the financial world:

1. Market risk. This is the risk that the price will decline due to market factors as well as changing economic, political or individual circumstances. Typically, investments in securities such as stocks, bonds and mutual funds will fluctuate over time, based on these factors. If you don't have a significant time horizon — perhaps, ten years or more — you might allocate a smaller part of your portfolio to securities.
2. Credit risk. Also known as financial risk or default risk, credit risk is generally associated with bond investments. Bonds issued by the federal government are considered to have minimal credit risk. On the other hand, high-grade corporate bonds generally carry a higher risk. Finally, junk bonds are known to carry the greatest credit risk. Note: Many bonds pay a premium or higher rate of interest to offset some of the credit risk.
3. Currency risk. Although investing on a global scale may provide growth opportunities, doing so adds additional risk relating to political, economic and market instability. In simple terms, currency risk is the risk that exists due to fluctuations in the value of the currency underlying securities in foreign investments.
4. Inflation risk. This refers to the risk that purchasing power will be reduced as inflation erodes the value of assets. In other words, it will cost you more tomorrow to buy the same items you bought today. To combat the long-term effects of inflation, you might take a more aggressive approach to stock and mutual fund investments that could outpace inflation over a period of time. Caveat: There are no absolute guarantees concerning rates of return.
5. Interest rate risk. This is the risk that you will be unable to reinvest your earnings and principal at maturity at the same rate if interest rates are falling. For example, if you have invested in CDs that pay 3% annually, you may not be able to reinvest in a CD paying as high as 3% when it matures.
6. Tax risk. No matter what happens in the financial markets, you can't avoid death or taxes. Remember it is how much you keep from your investments — not how much you earn — that truly matters. You can take steps to minimize the tax erosion from your investments with assistance from a financial professional.

There is no getting around risk if you're going to invest. The question is, how much risk are you willing to assume? The answer is something you should decide with a trusted adviser based on what your goals are, when you need the money and how much risk you can tolerate without losing sleep at night.