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When you hear the word ‘risk’ in the context of investing, what usually comes to mind is the risk that you’ll lose some or all of your investment. The blind spot that many people have here is that there are more risks to investing than just the risk of loss, which is technically called “market risk.” There are actually three kinds of risk to which investments are subjected: market risk, inflation risk, and emotional risk.
Every investment, including investing in a house, an education, a savings account, or a stock, is subject to at least one kind of risk. When people get nervous about the markets getting crazy, they often go looking for a “safe” investment, typically cash. But before you make investment decisions to keep your money “safe” and avoid risk, it’s important to know about all types of risk.
Market risk is the one that gets the most attention because it’s what you suffer from when the stock market plunges and your 401(k) balance goes down. It’s also the sexiest, so it tends to get all the headlines. If you only invest your retirement funds to protect yourself from market risk by sticking with bonds or CDs, you’ll suffer from one of the others.
Investing in real estate or education also has market risk, you’re just a lot less likely to see a sharp drop in value than you would with stock market investments.
Inflation risk is slower and less obvious. You’re not going to see a news report on how you lost 2 percent of your savings due to inflation in one day. Instead, inflation risk eats away at your purchasing power over time. For example, if you bought a new car today, it might cost you about $26,000. If the next forty years of inflation reflect the previous forty, the same car will cost you $145,000 in 2053 [Source: Worth It… Not Worth It? by Jack Otter].
It feels safer to keep your hard-earned savings in cash or CDs because you won’t ever see it dissolve in a flash crash of the market, but what you’re really doing is just trading your market risk for inflation risk.
Emotional risk is actually the biggest risk for all investors, although it’s difficult to measure. Waiting to buy until you see that the market is doing ok has you buying high; selling when the world seems to be going on the brink of a financial meltdown is selling low. Surely you’ve heard the adage, “Buy low, sell high.” Emotional risk is what causes most people to do the opposite.
The next time you quaff about investing in the stock market because you don’t think you can stomach the risk, remember that it’s just market risk that you’re acknowledging. Avoiding it guarantees you inflation and emotional risk, assuming you have a timeline that can weather the ups and downs brought by market risk, which is really just the risk of short-term loss of value – over the long-term market risk is leveled off. To mitigate, you need to invest in a diversified mix of stocks, bonds, and cash. The exact allocation to each class will depend on your age, investing goals and yes, your risk tolerance.
To account for emotional risk, you should set your account to automatically rebalance at least annually and ideally use dollar-cost averaging to your advantage, by regularly investing regardless of where the market is. Most 401k plans and online investment accounts allow you to do this, which keeps you from letting your emotions get in the way of smart investing.
We’ve answered the question of why you should invest, but keep in mind that you shouldn’t invest any money that you know you will need within the next 5–7 years — that’s best kept in cash so that it’s there when you need it. It’s worth the risk! (inflation risk, that is)
Disclaimer: The information in this article is not intended to encourage any lifestyle changes without careful consideration and consultation with a qualified professional. This article is for reference purposes only, is generic in nature, is not intended as individual advice and is not financial or legal advice.