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NASD Alert: Understanding Risk

A look at one of the most important concepts of savvy investing.
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Editor's note: This is a special alert from the NASD. University has reposted it for our readers.

Investing always means taking a

risk, but not every investment carries the same level -- or even the same type -- of risk.

For most people, risk means a possible loss of

principal. But the risk of investing in insured products introduces the possibility that your

rate of return won't outpace the

rate of inflation. In other words, your

account balance might increase over time, but your buying power might decrease anyway.

Risk falls into two main categories: investment risk and

portfolio risk.

Several elements contribute to investment risk, or the potential loss in value of individual investments:

  • Company risk. Stock values drop due to a company's internal problems or investors' hanging attitudes about its products and services.
  • Market risk. The overall value of stock or bond market drops, taking most investments down with it.
  • Interest-rate risk. Bond and bond fund values drop due to changing interest rates.
  • Credit risk. Bond issuers fail to make regular interest payments or repay principal upon maturity.
  • Currency risk. Exchange rates fluctuate and affect the value of overseas investments.

Portfolio risk affects your overall account value and results from your particular combination of investments:

  • Inflation risk. Low-risk investments with lower returns fail to outpace the rate of inflation.
  • Diversification risk. Portfolio money is concentrated in too few investments that drop in value.
  • Employer stock risk. Retirement savings are tied too closely with primary source of income -- if one goes badly, so does the other.
  • Time-horizon risk. Frequent reallocation doesn't allow for long-term growth.

Of course, you don't face all of these risks with the same investment at the same time. Rather, risks tend to be cyclical, with one risk posing a serious threat in some periods but very little in others. For example, rising interest rates haven't been a risk in the last several years. In contrast, company and market risk have had a strong negative impact on stock values.

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Liquid Assets

When it comes to assessing risk, you should consider the investment's

liquidity, or how easy it is to buy or sell the investment. For example, you can always sell stock in large corporations at the current market price, though you may lose some principal if the price has dropped since your purchase. Real estate, on the other hand, is not liquid, because you must wait to find a buyer and negotiate the price.

Risk and Return

One basic rule of investing is that there's a direct connection between risk and

return, sometimes described as reward. Making investments of varying levels -- and types -- of risk can help ensure that your portfolio provides both stability and growth. Equally important, combining investments that pose different risks may help you weather economic storms and can help you protect your principal and take advantage of opportunities for growth.

You may be willing to take the risk of losing money on stock, stock

mutual funds and other

equity investments. That's generally because you expect equities will increase the value of your retirement account more quickly than less-volatile investments. Historically stocks in general, though not each individual stock or stock fund, have provided a return nearly double that of bonds over the long term despite sometimes dramatic short-term losses. Keep in mind that in 23 individual years since year-end 1925, stocks have lost money.

In contrast, conservative investments that reduce your risk by guaranteeing your principal and sometimes the return you will earn generally offer more modest rewards. The greatest risk is that these investments won't provide the long-term growth you need to build your account value, especially during periods of high inflation, where your rate of return may be less than the rate of inflation. Some of them, such as

guaranteed investment contracts (GICs), stable

value funds, or

fixed annuities may also charge higher fees or impose penalties if you want to move money out because you revaluate the rewards they provide.

It's important to understand the difference between the investments in your

401(k), from the most risky to the least. Then you can create a portfolio designed to help you meet your goals with the level of risk you're prepared to tolerate.

Investments generally fall into three different asset classes, which carry different levels of risk and return: