All types of investments have risks, whether you’re investing in stock funds, bond funds, or even money market funds.
* Market risk: One of the most significant risks you face is the volatility of the market. Stock prices overall can decline—sometimes dramatically—over short or even long periods. You can reduce market risk by holding stock investments for a long time—at least ten years.
* Investment style risk: Returns from the types of stocks a fund invests in—such as growth or value stocks—may trail the returns of the overall market for short or long periods.
* Specific risk: If a fund’s holdings are concentrated in a particular company or industry, the fund’s performance can be significantly affected by developments in that company or industry. This risk is generally higher for sector funds.
* Manager risk: Poor security selection by the manager could cause a fund to under perform other funds with similar investment objectives. You can virtually eliminate manager risk by investing in an index fund that seeks to track the performance of all or most of the U.S. stock market. In choosing a fund with active management, take a look at the investment advisor’s years of experience and track record.
International stock funds have these additional risks:
* Currency risk: A weaker U.S. dollar increases the value of foreign assets owned by U.S. investors, but a stronger U.S. dollar diminishes the value of foreign assets owned by U.S. investors.
* Country risk: Events in a specific country—such as political upheaval, financial troubles, or a natural disaster—can drive down the stock prices of companies in that country. Country risk is generally higher for emerging market funds.
* Liquidity risk: Lower trading volumes can make it harder to buy or sell securities in some countries. This may cause increased price volatility and higher transaction costs.
* Interest rate risk: Bond prices fall when interest rates rise, and prices rise when rates fall. The longer a bond fund’s average maturity, the greater the interest rate risk.
* Income risk: When interest rates decline, a bond fund’s income will fall, so an investor’s income will also fall.
* Credit risk: Bond fund investors can lose money if an issuer defaults or if a bond’s credit rating is lowered.
* Call risk: When interest rates fall, a bond issuer may decide to repay a higher-yielding bond before its maturity date. When this happens, the fund must reinvest the money, often at a lower yield. (A similar risk—prepayment risk—affects mortgage-backed securities. When interest rates fall, homeowners may decide to repay their mortgages before the maturity date.)
* Inflation risk: The rate of inflation could be higher than a fund’s yield for short or even long periods, thereby eroding the purchasing power of your investment.
Money market funds
* Income risk: When interest rates decline, a money market fund’s income will fall, so an investor’s income will also fall. Since money market funds typically react to increases or decreases in market interest rates more quickly than bond funds, income risk is higher for money market funds than for bond funds. The reverse is also true: When interest rates rise, the yields of money market funds tend to rise quickly in response.
* Inflation risk: Because money market funds seek to maintain stable share prices, they offer no opportunity for capital gains. The rate of inflation could be higher than the yield on a money market fund for short or even long periods, so the purchasing power of your investment could decline.
Before you begin allocating your money among the three asset classes, you need to know your own risk tolerance. Are you willing to endure wide price swings in the pursuit of long-term growth, or are you more concerned with preserving principal?
While stocks are generally riskier than bonds or money market investments, stocks also offer the opportunity for higher returns.
The returns of stocks, bonds, and cash investments usually don’t all rise or fall at the same time. When returns for one asset class fall, those of another asset class may rise. When you diversify and invest in different asset classes and across asset segments, you can lower your overall risk by spreading the risk around.