The Primary Risk of Investing: Permanent Loss of Capital
When you put your hard-earned money into investment
vehicles, such as stocks, bonds or mutual funds, you take on certain
risks—credit risk, market risk, business risk, just to name a few. But the
primary risk of investing is not temporary price fluctuations (volatility), it
is the permanent loss of your capital. Otherwise known as investment risk,
permanent loss of capital is the risk that you might lose some or all of your
original investment, if the price falls and you sell for less than you paid to
All types of investments carry inherent risk(s): a stock
price may drastically decline; the issuer of a bond may default; even cash
investments (U.S. Treasury bills or money market funds) may lose ground to
inflation. So, you are probably asking yourself, “Why would I risk losing some
or all of my money?” No matter what investment vehicle you choose, the
objective is always the same: to generate more cash for yourself in the future
than you have today. If you keep all your money under your mattress, for example,
your balance will never grow beyond the amount you save. By investing your
money, the potential exists for you to come out ahead—perhaps even far ahead.
(See The Power of Compounding)
Risk vs. reward
Typically, an investment that carries higher risk has the
potential to generate a higher return (the risk-return tradeoff). In other
words, the greater the amount of risk you are willing to take, the greater your
potential reward could be. For example, a U.S. Treasury bond is considered one
of the safest investments there is; therefore, it provides a low potential
return. Stocks, on the other hand, are much riskier than Treasuries and, thus,
have the potential to deliver higher returns.
In light of this risk-return tradeoff, you must determine
your personal tolerance for risk when choosing investments for your portfolio.
Taking on some risk is often the price you must be willing to pay if you want
to achieve higher returns.
How do I determine my tolerance for risk?
Your answer will primarily depend on:
- Your age: Generally, the younger you are, the more risk you
may be willing to take because you have more time to make up for any losses you
might experience along the way.
- Your current financial responsibilities (risk capital): If
you are the primary earner for your family, for example, you may want to take
on less risk than you would if you were single.
- Your current financial resources (net worth): The larger
your investment pool, the more willing you may be to take on risk. Just make
sure you can still manage comfortably if you experience any big losses.
- Your time frame: When do you plan to withdraw the money? The
markets are subject to short-term fluctuations. If you invest money you plan to
use soon, you could be forced to sell when the price is down.
- Your timeline: How long will you need the money to last? As
you get closer to retirement, it is often recommended you move at least some of
your assets out of more volatile stocks and/or stock funds into
income-producing bonds and/or bond funds. You may want to consider leaving at
least a portion of your investments in equities (with growth potential) in case
you live longer than you expected.
Are there things I can do to help manage risk?
Invest for the long term
Try not to dwell on short-term performance. If you invest in
a company with strong business fundamentals, short-term price fluctuations may
not affect the long-term value of the company. Short-term periods of volatility
can even present a great time to buy more, if you still believe in the company.
Diversification simply means investing in a variety of
assets, with the hope that positive performance of some investments will
neutralize any negative performance in others. The goal of diversifying is to
build a portfolio that includes investments that react differently to the same
economic factors, limiting the risks associated with “putting all your eggs in
Beyond just assets classes, you can diversify even further
by allocating your money to different subclasses. For example, within the stock
category you can choose subclasses based on different market capitalizations:
large companies, mid-sized companies and some small companies. You might also
include securities issued by companies that represent different economic
sectors. If you're buying bonds, you might choose bonds from different types of
issuers: corporations, the U.S. government, etc.
Many retail investors have a limited investment budget,
making it difficult for them to put together a diversified portfolio on their
own. Buying shares of a mutual fund can provide a readily available source of
Be honest with yourself about your tolerance for risk.
You may find that the more you learn about how investments
work, the more comfortable you feel about taking risk. If not, remember that
there are professionals who can help you. Consider investing in an actively
managed mutual fund, or hiring a knowledgeable financial advisor to help lead
you on the right path. In the long run, the cost of investing your hard-earned
money in something you don't really understand can be much higher than the cost
of hiring a professional to do it for you.
Remember, a loss isn't truly “locked in” until you sell.
The reason you purchased an investment vehicle in the first
place is because you believed in its potential for growth (its value would
increase). If your reasoning has changed, or if the investment isn't performing
like you thought it would, you may want to consider selling. But before you
sell a losing investment, take a moment to decide whether the downturn is
simply a short-term blip (maybe even an opportunity to buy more) or whether it
is truly a permanent risk to your capital.