Market Risk — Riding those market ups and downs
Generally, stocks and stock mutual funds have the most market risk because they tend to fluctuate in value more sharply than bonds or stable value investments. This higher level of risk is why stocks have historically offered higher returns. Investors should seek a comfortable balance between potential risk and potential return, and remember that past performance is no guarantee of future results.
You can help manage risk by spreading your money around.
Manage market risk with asset allocation
One of the best ways to manage market risk is with asset allocation — the percentage of your money you put into different asset classes or investment types. Asset classes tend to perform differently from one another over time. Large cap stocks may perform best one year and the next year international stocks will be the best performer. Then the following year bonds might beat them all. Asset allocation has a greater impact on the performance of your investments than any other single factor. Keep in mind, asset allocation does not guarantee a market gain or protect against market losses.
A properly allocated investment may help to balance out the investments that are doing poorly. Since your returns are an average of all the asset classes in your portfolio, asset allocation helps to level out the dramatic ups and downs of any particular category and may reduce your overall market risk.
Drill down with diversification
Diversification is another way you can manage market risk. Diversifying your portfolio means spreading your investments (and spreading your risk) across multiple investments. This helps to reduce the impact a single investment has on your performance. For example, by diversifying across multiple stocks, you lessen the impact of a loss in any one company. Mutual funds provide automatic diversification because they invest in multiple securities—stocks, bonds or sometimes both.
Take advantage of market risk
As a retirement investor, you need to accept a certain amount of market risk if you want the growth potential that comes from investing in stocks. Although asset allocation and diversification cannot guarantee a profit or protect against loss, they are well-recognized risk management strategies that can help smooth out volatility.
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Stocks are more volatile than bonds, and portfolios with a higher concentration of stocks are more likely to experience greater fluctuations than a portfolio with a higher concentration in bonds. Foreign stock and small- and mid-cap stocks may be more volatile than large-cap stocks. Investing in bonds also entails credit risk and interest rate risk.