Understanding Investment Risk

Risk is a term used in investing to signify the potential for gains or losses in a particular investment. It is common belief among investors that a greater return on investment can be achieved the higher the investment risk. The key to minimizing risk and making gains in investment may be contained in a well-managed diversified financial portfolio.

investment risk

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A diversified portfolio is one that contains high risk investment opportunities, such as purchasing of single stocks and mutual funds, and low risk investments, such as a savings account, certificate of deposits, or treasuries. There are three main types of investment risk.

1) Market Risk

Market risk is inevitable. When choosing to invest, there is no escaping the concept of risk. Anything can affect the market and determine its risk factor. For example, inflation’s average increase of three percent per year is a common determinant in market risk. Another major example for many worldwide investors was the drop in the world economy. This drop plunged the stock market and affected millions of investors. The risk can also be company specific, such as low profitability.

2) Passive Management Risk

This type of risk can be personally managed by conducting research on the company in terms of its profitability and sustainability over a certain period of time. Studying the history of a company may give you a better view on that particular investment in terms of how it operates.

This type of investment is usually associated with index type investing, such as a mutual fund group with a diversified portfolio. The risk of losing or gaining in the investment is directly related to the overall management of the fund company. Management factors will determine the price of the fund in the market, either upwards or downwards.

3) Active Management Risk

Active risk refers to the risk involved with active trading of the fund or stock in the market. By being actively traded on the market with current prices, there could be a higher return on investment, but it comes with a high risk. In the investing world, this type of portfolio is of the highest risk, as the gains or losses are solely determined on the market fluctuations throughout the time the market is open.

The Bottom Line

Risk may not be able to be avoided, but there is always a way to reduce risk with a diversified financial portfolio. Investing is a reasonable way to earn extra income for retirement or any other major life event. It’s the longevity that influences your investment strategy.

 

About Peter Philipp, CFA, CFP®

Peter Philipp specializes in employee benefits and investment management for businesses and individuals. In 1993, he helped launch the world’s first target-date funds, a concept which has become the cornerstone of today’s 401(k) plans. Peter holds both the Chartered Financial Analyst designation and the CERTIFIED FINANCIAL PLANNER™ certification, an elite distinction since less than half of 1% of all financial advisors are “dually‐certified.”


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