Rule #6 Understand Risk, and Take Steps to Help Reduce It
Every investment carries some form of risk. The amount of risk you take can often go hand in hand with the potential return an investment offers. It’s important to understand investing risks and take steps to help reduce them.
Business/Credit
Financial difficulties could cause a bond issuer to fail to make
timely interest or principal payments. A company’s stock may
decline significantly in price or become worthless. Diversify your
portfolio to help reduce this risk. Limit your holdings of any
individual security to no more than 5% of your overall investments.
In the case of mutual funds, one fund can be more than 5% of your
portfolio because it holds a variety of individual securities.
Market Changes
Market changes will cause the value of your investments to
fluctuate. A decline can be triggered by negative economic events,
a change in fiscal or monetary policy, political uncertainty,
changing industry regulations, war or other international events.
It’s impossible to eliminate market risk if you own stocks, mutual
funds or bonds. But we believe buying quality investments, which
are more likely to bounce back when the decline is over, is the
best strategy for investors with long-term goals.
Inflation
Prices tend to rise every year. Your future purchasing power –
what a dollar will buy – is uncertain. An inflation rate of just 3%
means everything you buy today will cost about twice as much in 25
years. Although they carry market risk, an appropriate amount of
growth or growth-and-income investments – stocks or mutual funds –
may help you keep pace with inflation. Also consider real return
bonds, which adjust their interest payments based on inflation.
Interest Rates
Changing interest rates can have a major impact on the value of
your fixed-income investments and the income you earn from them.
Investments with shorter-term maturities offer the potential for
stable principal values, but the income can fluctuate greatly.
Longer-term fixed-income investments offer the potential for a
steady rate of income, but their principal value may experience
larger price swings as interest rates rise and fall. Staggering
maturities by investing in short-, intermediate- and long-term
investments should help even out the wide swings in your principal
and income.
Liquidity
For some investments, there may not be a buyer when you want to
sell. So it may take longer, cost you more or force you to accept a
lower price. Liquidity risk means you may not be able to buy or
sell an investment on any business day without large penalties,
commissions or price concessions. The best way to help reduce this
risk is to limit the number of investments you own that have these
characteristics.
Valuation
A successful company and a great stock may not be the same thing.
You might pay more money for an investment than it’s worth. If
you’re buying a quality stock at a smart price, we believe your
return is likely to be attractive. Smart consumers shop for value –
smart investors must do the same. Pay attention to traditional
measures of value when investing in individual stocks.
Currency Fluctuations
Changes in currency exchange rates are unpredictable and can have
a significant impact on the value of your international
investments. Often a falling dollar means the value of foreign
shares will likely rise, and vice versa. You can limit this risk by
diversifying an appropriate amount – we recommend 30% to 45% for
most investors – in international investments.
Diversification does not guarantee a profit or protect against loss.
Dividends can be increased, decreased or totally eliminated at any time without notice.
Past performance doesn’t guarantee future results.
Special risks are inherent to international investing including those related to currency fluctuations and foreign political and economic events.
