The Short Course on Investment Risk

Risk and return. They're kind of like the bacon and eggs of the investing world. Here's the recipe: The higher the potential return, the higher the potential risk. In other words, the more money you expect to make from an investment, the greater your risk of losing money. Your job, as investment portfolio chef, is to keep this risk and return relationship balanced.

What goes up might come down
There are many different kinds of investment risk, but for most investors, "risk" simply means the chance that you'll lose money if the value of your investment falls below the price you paid for it. This is called market risk.

All investments have varying degrees of market risk, with stocks and stock funds generally having the highest and short-term investments such as U.S. Treasury bills the lowest. An investment with high market risk is considered volatile, meaning its value may go up a lot or down a lot, especially over the short term.

Not going up enough could be a problem
The other major risk for long-term investors is the risk of falling short of your investment goal. This could be caused by not saving enough or focusing on investments that can't give you a high enough return. Let's call it "retirement shortfall risk." If you invest in so-called "safe" investments like Treasury bills, federally insured bank CDs, or other low market-risk investments without balancing them with higher-return investments such as stocks and stock funds, you're likely to have a portfolio that will not grow enough to meet your goal. That is, you'll have a very high level of retirement shortfall risk.

Perhaps no question is as personal as "how much risk are you comfortable with?" One investor may be completely comfortable with a portfolio comprised of aggressive stock funds. Another might lose sleep over the performance of a relatively stable government bond fund. When determining the amount of risk that's right for you, think about two critical factors: Time horizon and volatility.

One critical factor in determining the amount of risk you can bear in your investment portfolio is to consider your investment time horizon, or the approximate number of years in which you'll need to access your investments. For example, a person with five or less years to retirement will likely want to invest more conservatively than another with ten or more years until retirement.

Based on past performance and current market conditions, how likely is it that the investment will go up and down in value in the short term? Would you be comfortable with the kind of volatility you might expect? If you're investing for a long-term goal such as retirement, will you be able to wait out cycles of volatility, or would the temptation to sell be too great for you? Remember, however, that even though the prices of stocks and bonds have gone up and down over short time periods, their values have steadily increased over longer time periods, with stocks making the greatest gains.

While different classes of assets have varying levels of risk attached to them, not even the most stable investments are entirely immune from prevailing market conditions. During a bull market, investment values tend to rise; in a bear market, they tend to fall. Regardless of the type of investment you have, it is likely to be affected by what's happening in the major markets as well as overall economic factors such as interest rates, the growth rate of the economy, the inflation rate and unemployment.

The amount of risk that you are willing to accept for your retirement savings may change over time. Events will occur that will change one's perspective towards investing. This is not a bad thing. It only means you need to continue to educate yourself about investing and need to monitor your account on an annual basis. Because your comfort level with investment risk is a personal matter, no one can tell you how much risk is right for you.

The best defense against investment risk is education. When you understand the difference between market risk (the risk that the value of an investment may rise and fall) and retirement shortfall risk (the risk that you've invested too conservatively to reach your financial goals) you'll be better able to put risk in perspective. Then, you'll be able to make investment decisions you can be comfortable with, now and down the road, also.

This site is one of many tools available to help you learn about saving for retirement. You can supplement the information provided with other sources such as personal investment magazines and books, the financial section of local and national newspapers, and commercial web-sites. A consultation with a financial planner may be necessary to determine what is right for you.

Please be advised that any of the information or content from other sources is neither supplied nor guaranteed by ING.