Understanding risk

When you make an investment, you risk the possibility that the value of your investments will go down or remain unchanged over time. Some investments are more risky than others. Generally, the more risk you’re willing to take, the greater your opportunity for reward over the long term.

There’s not a simple formula to follow to determine how much risk is worth taking; only you know how much or what kinds of risk you’re comfortable with. What’s more, your willingness to accept certain levels of risk will probably change during your lifetime.

Start to determine your comfort level with risk by asking yourself two questions:

1. What are my retirement goals?

The more specific you are, the easier it will be to determine the level of return you’ll need and the level of risk you’ll need to accept to potentially reach those goals.

2. When do I want to retire?

If retirement is a long way off, you might consider more aggressive investments. A span of several years gives you the opportunity to ride out the ups and downs of a number of market cycles. But if you’re close to retirement, you might want to shift to investments with lower risk. In either case, talk to a financial professional to see what makes sense for your situation.

Next, you’ll need to evaluate your investment options. Most investments fall into one of three broad categories:

• Stocks and stock funds — Historically, these have offered the highest potential reward but tend to have the highest risk and are more appropriate for long-term investors.
  
  
• Bonds and bond funds — These typically present less risk than stocks but generally have less growth potential than stocks.
  
  
• Cash alternatives — This category includes money market funds, or stable value funds, and offer the least volatility. Investors generally use them to help preserve what theyve invested.

Losing money is an obvious risk with any investment, but there are others you may not have considered:

• Risk of inflation

  Inflation eats away at the value of a dollar. If your investments don’t keep pace with the rising cost of living, you’ve lost buying power.

  If you are a conservative investor or will be retiring soon, you may be attracted to cash-equivalent investments. Consider including enough stock or bond fund investments to keep you from falling behind rising costs. Keep in mind that much of your investment portfolio might still have a 10- to 30-year time horizon once you retire.

• Market risk

  Another word for market risk is volatility. Volatility may cause you to lose money if you need to sell your investment in the near future.

  Diversifying your investments and contributing regularly over a long period of time could help you address market risks. There’s no guarantee that putting your money in a variety of investments will eliminate risk, but it could help.

  • Merits of diversification

    Having a mix of stock and bond funds in your portfolio could help offset losses. Gains in one or more of your investments might balance out the losses you have in others.

  • Riding out cycles

    Investing over the long term won’t guarantee you a profit or prevent you from losing money, but making a regular fixed-dollar investment (called dollar cost averaging) can help compensate for the natural up and down cycles in the market. Because the prices of mutual funds fluctuate, dollar cost averaging allows you to buy more shares when prices are lower, and fewer shares when prices are higher, which could help lower average cost per share. Before using this strategy, though, make sure to consider your willingness to continue investing while share prices are declining.

• Risks of investing outside the U.S.

  Though there are unique risks associated with investing outside the U.S., the international marketplace may have a lot to offer some investors. Foreign markets often move in their own market cycles, so investing abroad may help to counteract the effects of a down U.S. market on your portfolio. Investing abroad involves risks, such as currency fluctuations, periods of illiquidity and price volatility, as more fully described in the prospectus. These risks may be greater with investments in developing countries.