Like most things in life, all investments have risk. When you make investment decisions, it’s important to understand the types of risk involved, and their relationship to the amount that you can earn on your investments (known as rate of return). This knowledge can help you create an investment strategy that’s best for your situation.
In general, there are two types of risk involved in investing: investment (short-term) risk and inflation (long-term) risk.
Investment (Short-Term) Risk
Investment risk is the risk that your investment may decrease in value in the near future (over the short-term). Take, for instance, the stock market. The value of a stock can fluctuate (increase and decrease) significantly over short time periods. For this reason, stocks are often referred to as “volatile” investments and have a higher level of risk than other types of investments.
At the same time, history has shown that stocks can be an excellent long-term investment. U.S. stock market returns have historically outperformed other types of investments and beaten the rate of inflation over the long-term. In general, you increase your ability to earn higher rates of return on your long-term investments (generally 10 years or more) when you take on more investment risk.
If you’re nearing retirement age, minimizing exposure to investment risk may be more important. The Annuity Plan benefit you receive at retirement is based on the value of your account when you retire and elect to begin payment of your benefit. So, as you prepare for retirement, you may want to minimize your chances of a sudden investment loss. However, if you have several years until you plan to retire, you may be more concerned about minimizing your exposure to inflation risk.
Inflation (Long-Term) Risk
Inflation (long-term) risk is the risk that the purchasing power of your money will erode because of inflation. Inflation is a serious risk for any long-term investor.
Conservative investors may feel that it’s “safer” to lower their short-term investment risk by avoiding stock investments. However, they miss earning potentially higher rates of return. A conservative investment strategy may be appropriate if you’re nearing retirement. If you invest too conservatively over long periods, you may be taking on unnecessary inflation risk.
By investing your money in different available options (diversifying your investments), you may be able to reduce your exposure to any one type of risk.