What Does Investment Risk Really Mean — and How Do You Manage It?
Few terms in personal finance are as important, or used as frequently, as "risk." Nevertheless, few terms are as imprecisely defined. Generally, when financial professionals or the media talk about investment risk, their focus is on the historical price volatility of the asset or investment under discussion.
Financial professionals often describe an investment as aggressive or risky if it has experienced large price swings in the past. The presumed uncertainty and unpredictability of this investment's future performance is perceived as risk. Assets characterized by prices that historically have moved within a narrower range of peaks and valleys are generally considered more conservative. Unfortunately, this explanation is seldom offered, so it is often not clear that the volatility yardstick is being used to measure risk.
On a practical level, we can say that risk is the chance that your investment will provide lower returns than expected or even a loss of your entire investment. You probably also are concerned about the chance of not meeting your investment goals. After all, you are investing now so you can do something later — pay for college, retire comfortably, or leave a legacy. Every investment carries some degree of risk, including the possible loss of principal, and there can be no guarantee that any investment strategy will be successful. That's why it makes sense to understand the kinds of risk, the extent of risk you choose to take, and ways to help manage it.
What You Probably Already Know About Risk
Even without formal training, you already understand risk from everyday experience. A scandal involving a company can cause its stock price to fall. A competitor’s breakthrough can pressure an industry. An economic slowdown can drag down the whole market. Risk is woven into the fabric of investing.
What Makes Volatility Risky?
Suppose you had invested $10,000 in each of two mutual funds 20 years ago, and both produced average annual returns of 10 percent. Imagine that one fund — "Steady Freddy" — returned exactly 10 percent every single year, while the other — "Jekyll & Hyde" — alternated between 5 percent one year and 15 percent the next. Though the averages are the same, the final values would differ: Steady Freddy’s account would end more than $2,000 higher. Short-term fluctuations drag down long-term growth.
The lesson: volatility matters. And if you need cash in the short run, it’s especially risky to hold volatile assets — you could be forced to sell at a loss.
Other Types of Risk
- Market risk: loss from overall market decline.
- Inflation risk: return doesn’t keep up with rising prices.
- Interest rate risk: bond values fall when rates rise.
- Reinvestment risk: reinvesting proceeds at lower rates.
- Default risk: borrower fails to pay.
- Liquidity risk: difficulty selling without loss.
- Political and currency risks: changes in policy or exchange rates affect investments.
The Relationship Between Risk and Reward
Higher potential reward comes with higher risk — but the key is ensuring the risk is appropriate for your goals and time frame. No strategy can eliminate risk, but planning helps ensure the risks you take are intentional and manageable.
Understanding Your Own Risk Tolerance
Risk tolerance has two sides:
- Emotional tolerance: your comfort with ups and downs.
- Financial tolerance: your ability to absorb losses based on your goals, age, and financial situation.
Too much risk may keep you up at night. Too little risk may prevent you from meeting your long-term goals.
Managing Risk: Diversification and Invest Policy Statement
Diversification — spreading investments across asset classes and within them — can help reduce exposure to any single risk. Stocks, bonds, and other assets don’t always move in the same direction, which helps balance volatility.
But diversification isn’t enough. It’s critical to have an Investment Policy Statement (IPS) — a written guide that defines your goals, risk tolerance, time horizon, and the strategies to keep your investments aligned. Think of it as your roadmap when emotions run high.
Markets will always swing — whether due to interest rate changes, tariffs, policy shifts, or political events. And when values feel “stretched” after a market run, it’s tempting to react emotionally. An IPS helps you resist emotional decisions, keeping you grounded in your long-term plan.
The Importance of Revisiting Risk Annually
Your life circumstances and the market environment change. That’s why it’s essential to revisit your IPS and overall risk approach annually with your financial advisor. Together, we can:
- Reconfirm your goals and time frames
- Adjust for changes in market conditions, tax law, or personal circumstances
- Ensure your portfolio still reflects your comfort with risk
Risk isn’t something to fear, but something to understand, plan for, and manage. With the right process — and a clear investment policy — you can navigate uncertainty with confidence rather than emotion - I’m here to help you make sense of it.
