When it comes to investing, analyzing the amount of risk you're exposed to can be tricky. On one hand, investors don't want to take on too much risk and lose their hard-earned money, but on the other, they don't want to stash their savings under their mattress and risk not seeing any appreciation over time. Lately, investors have been doing more of the latter—staying out of the market for fear of losing more money after one of the worst downturns in decades.
Earlier this month, Prudential released a survey in which a majority of individual investors (58 percent) said they've lost faith in the stock market. Every financial decision an investor makes carries risk, so it's important to be aware of how your portfolio is positioned. Here a six risks every investor faces:
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Capital risk. This is the most obvious risk. When you invest in stocks or bonds, you run the risk of losing your capital. A closer examination reveals that there is much more to the story than just losing money.
Upside risk. Often overlooked, upside risk refers to occasions when investors are too conservative and miss a rally. "Upside risk is poorly understood, but it's even more detrimental [than capital risk] in some cases to achieving an investor's objectives," says Douglas Coté, senior market strategist at ING Investment Management. "Because of this misunderstanding of risk, investors have piled incorrectly into cash, which has created its own risk—the risk of not participating in growing markets." The amount of cash investors have on the sidelines in low-yield vehicles like money market funds and savings accounts currently stands at a record high of about $7 trillion, according to FactSet, a research company. "We call cash a dead asset," Coté says, because it yields virtually zero and has no potential for capital appreciation. He advocates a strategy in which investors leave nothing on the sidelines, so they can reap the maximum benefits of compound returns over time. Last year, a fully invested, broadly diversified portfolio with a 60 percent allocation to stocks (both U.S. and foreign, small-, mid-, and large-cap, and real estate investment trusts) and a 40 percent allocation to bonds of different types and maturities returned 14.5 percent, Coté says.
Concentration risk. Having a lot of investments and being diversified are two different things. "Tracking your individual stock exposure is a great idea," says Christine Benz, Morningstar's director of personal finance. For instance, a lot of large-cap U.S. stock funds hold many of the same big companies that represent large positions in the S&P 500. It's important to have exposure to big U.S. companies as well as smaller ones and foreign stocks. Some employees also own company stock, which you may already hold within a stock fund.
Correlation risk. Having a diversified portfolio means more than just owning a mix of stocks and bonds. It requires investing in non-correlated assets. By buying uncorrelated assets, an investor reduces his or her overall risk. "When you add a volatile, high-return asset class like emerging markets to a well-diversified portfolio, it both reduces risk of the overall portfolio and increases return," Coté says. Investors with emerging markets exposure benefited from a huge rally after 2008's downturn. And during the market meltdown, long-term U.S. treasuries, a traditional safe-haven asset class, gained 34 percent in 2008, while most other asset classes tanked.
Overpaying. Morningstar research shows how important fees are in predicting the success of mutual funds. The firm looked at the expense ratios of funds in multiple asset classes from 2005 through 2008, then tracked their progress from 2008 through March 2010. Research found that the cheapest funds outperformed the highest-cost funds in each asset class over every time period. For instance, in 2005, the cheapest quintile of U.S. stock funds returned 3.35 percent, on average, over the five-year period, versus 2.02 percent for the highest-cost quintile of funds in the category. "It's so easy to ignore this risk because when you look at these numbers in percentage terms, they seem really small," Benz says.