In a world that's full of scary news, everybody wants a safe investment that produces big returns. Yet while most people understand that their wishes for high returns with minimal risk are unrealistic, they often have the wrong thought process about why they can't find that perfect investment.
The confusion comes from thinking of risk as a single concept. Rather, investors face a huge number of different types of risks, and no one investment can address every single one of them. In order to come up with a strong portfolio, you have to balance all the risks you face and determine which ones you're best prepared to handle and which you absolutely have to protect against.
By far, the type of risk that investors pay the most attention to is market risk. As we saw four years ago, under some circumstances, a bad stock market can pull down the value of even the strongest companies in the world.
Typical asset allocation strategies aim primarily at protecting against market risk. So when investors are nervous, they load up on assets like bonds, gold, real estate, and other alternatives to stocks in the hope that they'll avoid a massive drawdown in their net worth during a market plunge.
But in reality, there are many other risks that investors often ignore. Consider just a small subset of risks beyond market risk:
- Purchasing power risk. Those who keep their money in cash or short-term CDs or bonds figure that by doing so, they've eliminated their market risk by guaranteeing the return of their principal. But over time, inflation erodes your purchasing power. The rock-bottom rates paid on cash and similar investments currently leave you completely exposed to that gradual loss of purchasing power.
- Interest rate risk. In order to get higher rates, bond investors often take advantage of the typically upward-shaped yield curve by locking in rates for longer periods. Yet by doing so, they accept greater volatility when interest rates move. Especially after the big drop in long-term bond rates over the past 30 years, the risk of capital losses if rates start to rise could be catastrophic to investors thinking that they've bought into "safe" investments. The same risks hold true for certain interest-rate-sensitive plays, including mortgage REITs Chimera Investment (NYS: CIM) and ARMOUR Residential (NYS: ARR) , which will likely suffer when rates start to rise.
- Deflation risk. One answer that investors have turned to over the past decade is to buy precious metals. With the ease of investing in SPDR Gold (NYS: GLD) , iShares Silver (NYS: SLV) , and a host of other commodity-related plays, investors hope to address inflation risk by getting rid of cash that can lose value at the whim of central banks in favor of hard assets that have inherent value. Yet gold and other commodities leave investors exposed to deflation risk. And while few average investors would consider deflation a real threat, part of the reason rates are as low as they are is because of concerns about a monetary contraction that could bring all asset values way down.
- Company risk. As any stock investor knows, picking the wrong company can cause losses even in a rising market. Although industry leaders can produce huge gains for shareholders, also-rans often result in big losses. Picking an eventual winner seems easy in hindsight but challenges the best investors.
- Default risk. Related to company risk, income investors have to assess the possibility that an issuer won't be able to make good on its obligations to repay debt. Those fears partially explain why municipal bond rates are so high compared to taxable government bonds.
- Dividend risk. As we saw in the financial crisis, investors who rely on dividends face special risks. Even if a company has reasonable survival prospects, the loss of a dividend can devastate income-needy investors. We've seen that play out in Europe, with France Telecom (NYS: FTE) and other high-yielding dividend stocks having to deal with payout cuts.
- Manager risk. Some investors give up trying to manage their own money and turn to professional managers to help them. Choose wisely, and that can help make you rich. But choose poorly, and it can cost you your entire portfolio -- regardless of what the market does.
All these risks may seem impossible to deal with. But while you can't eliminate risk entirely, you can determine which ones you fear the most and which aren't important to you. Then, figuring out the right way to invest becomes a lot easier -- and more closely reflects your own individual risk tolerance.
It may seem hard, but you can still handle risk and build the retirement portfolio you need. Find out how from The Motley Fool's special report on investing for retirement. Inside, you'll find three smart stock ideas along with helpful advice to build protection against risk and get the returns you need. Just click here and start reading your free copy right now.
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At the time this article was published Fool contributor Dan Caplinger embraces risk. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of France Telecom. Motley Fool newsletter services have recommended buying shares of France Telecom. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy handles disclosure risk like a pro.
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