With all investments there is some degree of risk. While you would ideally like to see your investment grow, it is possible, and at times likely, that you will lose money. Unlike your savings and checking accounts, investments are not insured by the Federal Deposit Insurance Corporation (FDIC). Therefore, you have no protection if you do lose money. This holds true for your retirement investments, mutual funds, college savings accounts and virtually every form of securities investments.
Understanding the risks associated with investing can help you make informed decisions and invest with confidence. Here is a listing of the types of investment risks and how to minimize them:
- Inflation Risk is the chance the money you have invested will decline in value as rising prices shrink the value of the dollar.
- Principal Risk is the degree of probability that your original investment will decline in value or be lost entirely.
- Credit Risk is the chance a borrower will default on an obligation.
- Market Risk (or volatility risk) is the likelihood that a broad investment market, such as the bond or stock market, will decline in value.
- Liquidity Risk is the possibility you won't be able to sell or convert a security into cash when you need the money.
Despite the risks listed above, it is still probably more risky not to invest at all. After all, history has proven that over time most investors win. For example, a dollar invested in stocks back in 1955 grew to $95 by the end of 1999. (This takes into consideration compounding interest.)
While there are other investment options available, such as bonds and Treasury bills, stocks have outperformed each by a wide margin. Further, stocks have historically outperformed inflation as well. A long-term investment strategy is what makes the difference and ultimately helps to reduce risk. In fact, according to Ibbotson Associates, since 1926 stocks have outperformed inflation by over seven percent.
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Avoiding Risk
To help avoid risk, it is best for you to do your due diligence by researching companies and funds you are interested in investing in. However, most importantly, it is best to seek the advice of a good licensed securities broker. Beyond that, understand that time is on your side when you invest. A long-term strategy usually equates to a return of some sort.
How long should you hold stocks?
The answer to this question will vary depending on your specific investment goals. But a rule of thumb should be at least 5-10 years. Time helps to reduce risks associated with investing. In fact, from 1901 to 2005, the chart below shows that most investors who held their investments for five years or longer earned money. (See chart below.)