Risk is inherent in stock markets and investment portfolios. Shifting headlines can push stocks one way one day, and another way the next. That’s especially true when economic data doesn’t land as predicted. But not all risks to investments are the same, and there may be rewards to taking some investment risk.
What is investment risk?
For an investor like you, investment risk refers to the degree of uncertainty and/or potential financial loss inherent in an investment decision. In other words, when you invest your money, you don’t know for sure if you’ll receive the desired returns or experience unexpected losses.
But risk to your investments doesn’t come just from stock market moves. The economy, length of investment time, and more all pose potential risk to your investments.
Types of investment risk
| The risk | What it is | Effect on investments |
|---|---|---|
| Inflation risk | The tendency for prices to increase over time | Future dollars (your investments) will not have as much buying power. |
| Longevity risk | The risk of outliving your savings | The length of retirement is undetermined, making it tough to know how much money you’ll need. |
| Market risk | The risk of loss due financial market performance | Stocks vary from day-to-day and year-to-year, which can have a negative effect on investments. |
| Interest rate risk | The risk to savings and loan rates if interest rates change | For money you want to grow (investments), interest rate increases are generally positive. |
| Credit risk (corporate bonds) | The risk of default by the issuer of the bond | Bondholders may not be paid the promised interest or the full principal. |
What are the pros and cons of investment risk?
So why subject yourself to investment risk? In general, the rewards of the return on investing may outweigh the rewards of return on traditional savings accounts.
However, investment risk varies from one type of investment to another, meaning the level of risk you take on is up to you. If short-term changes in the value of your investments don’t bother you, you’re probably fine taking on some amount of investment risk. However, if the thought of a drop in value—even for one day—gives you the chills, then taking less risk might be more your speed.
Tip: Market volatility ≠ Market risk
Market volatility is how frequently and significantly an investment changes price over time.
Market risk is the probability that a change will result in permanent or long-lasting loss of value.
In addition, some types of investment risk help counteract other types of investment risk. Take inflation: It causes prices to increase over time. If you want your investments to keep pace with the risk of those increases, you may need to take on some risk.
Finally, when you think about investment risk, it’s helpful to balance short-term wariness with long-term opportunity. Look at the stock market: Some years for the S&P 500 have been better than average and some worse. Over the long haul, however, there have been fewer negative periods than positive. For the investors who took the risk and kept their money in, even when the markets were wobbly, the value of their investments likely increased.1
See for yourself how this plays out with our case study on the extreme volatility in 2008 and 2009.
Next steps:
How much are you saving for retirement every year, no matter what the markets do? Log in to your Principal account to see how you’re doing and adjust. First time logging in? Get started by creating an account.