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Investment Risk Tolerance and Types of Investment Risk

Before starting investing in the vast realm of mutual fund you should carefully consider the level of your risk tolerance. In the short-term, risk can be defined as price volatility or variability, whereas in the long-term perspective, risk is viewed as the possibility of being unable to financially meet you goals due to insufficient capital.

Every person possesses different levels of risk tolerance. For example, many investors are comfortable with short-term price volatility, whereas other panic only when the small variance in the price of their shares occur.

You should be well aware that there is no investment that is risk free. A good distinction between the different types of investment opportunities can be made by comparing capital risk to income risk. For example, over the mutual fund history, stocks have proven stable growth in dividends while their market value has been highly unstable. On the other hand, bonds have proven their importance as a component of every investment portfolio since they provide high and durable income levels despite their fluctuations. Money market funds and bank deposits present a high income risk, despite their capital stability.

As for mutual funds, thanks to diversification and automatic investing, investment risk can be sufficiently decreased. This is also due to their flexibility, which facilitates the achievement of the long-term investment goals of investors that have chosen them.

In order to build a successful in financial terms investment portfolio, you should identify your risk tolerance level.

Risk Types

There are different types of risk that can be encountered. Some of them are as follows:

  1. Inflation Risk (also known as loss of purchasing power)

    Inflation risk occurs when you can buy less with your income due to a more rapid increase in the prices. Additionally, inflation risk is observed when the earnings on your investments lag behind with respect to inflation rates.

  2. Market Risk (also known as systematic risk)

     

    Due to outside factors the prices or yields of securities from a particular market can rise or fall, which may greatly affect the stocks of all types of companies.

  3. Credit Risk

    The risk of the inability of the company you invest in to return your money always exists. You should keep in mind that it is possible that the company may not be able to pay you the promised interest and return you the principal when the time comes.

  4. Currency Fluctuations Risk

    The value of every currency is subject to fluctuations from which you can lose money. Due to globalization, you don't need to invest in foreign securities to avoid fluctuations.

  5. Interest Rate Risk

    Interest rate fluctuations can be offset by diversification in the investment portfolio. Both stocks and bonds are not safe from the interest rate fluctuations.

  6. Political Turmoil Risk

    The political situation both at home and abroad should be considered because it may affect the willingness of investors to make investments.

Every company is affected differently by the various risks. Therefore, the key is to diversify in order to offset the effect of a potential risk.

The Risk in Mutual Funds

Mutual funds deserve their popularity due to the fact that when you purchase shares of one, you immediately enjoy diversification. In order to further decrease the risk of sustaining losses, you can purchase shares of different mutual funds and thus buy different securities. In this way you eliminate the need of constantly observing market conditions and adjusting your portfolio in accordance to them. A combination of high-risk/high-capital growth funds with low-risk/high-income funds can be a suitable recommendation. You should also consider the tax bracket in which you fall so that if it allows it to include tax-exempt mutual funds.

In order to balance your risk and achieve greater financial returns, diversifying among stocks, bonds and money markets is recommended.

When you decide on the level of risk acceptable to you, you should also consider the time you have ahead of you. For instance, if you are nearing retirement you should implement a more conservative investment style since you don't have enough time to recover potential losses as compared to a younger investor.

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