Smart 401(k) Investing—Investing in Your 401(k)

Understanding Risk in Your 401(k)

 

Investing always means taking a risk, but not every investment carries the same level—or even the same type—of risk. As an investor, you should be familiar with the different forms of risk that can affect your portfolio, including the following.

• Company risk. Stock and bond values drop due to a company’s internal problems or investors’ changing attitudes about its products and services.
• Market risk. The overall value of stock or bond market drops, taking most investments down with it.
• Interest-rate risk. Bond and bond fund values drop due to changing interest rates.
• Credit risk. Bond issuers fail to make regular interest payments or fail to repay principal upon maturity.
• Currency risk. Exchange rates fluctuate and affect the value of overseas investments.
• Inflation risk. Some low-risk investments—although not Treasury Inflation Protected Securities (TIPs) or I Bonds—with lower returns fail to outpace the rate of inflation.
• Diversification risk. Portfolio money is concentrated in too few investments that drop in value.
• Employer stock risk. Retirement savings are tied too closely with primary source of income—if one goes badly so does the other.

Of course, you don’t face all of these risks with the same investment at the same time. Rather, risks tend to be cyclical, with one risk posing a serious threat in some periods but very little in others. For example, rising interest rates haven’t been a risk in the last several years. In contrast, company and market risk have had a strong negative impact on stock values.

 

Risk and Return

 

As we have discussed, investing always involves some degree of risk. One basic rule of investing is that there’s a direct connection between risk and return, sometimes described as the “risk/reward tradeoff.” In general, the higher the risk that you could lose money, the higher your potential returns. Similarly, the less you can afford to lose money on an investment, the less risk exposure you will want to assume.

 

Making investments of varying levels—and types—of risk can help you position your portfolio for both stability and growth. Equally important, combining investments that pose different risks might help you weather economic storms, and can help you protect your principal and take advantage of opportunities for growth.

 

When deciding how to invest your 401(k) assets, be sure to consider the various risks each investment choice carries as well as how much risk you are taking elsewhere in your portfolio (outside your 401(k)) and what form that risk takes. For example, if you work for a publicly traded company, your job could be on the line if the company performs poorly—and any deferred compensation in the form of company stock could be at risk. This is sometimes called "human capital" risk. Remember, your risk analysis will always be unique to you. If you have limited assets or assets that you cannot or are not willing to lose, then you will want to think twice about the risks you take—especially risks that could result in your losing your principal or seeing the value of your investment eroded by inflation.

 

So it’s important to understand the difference between the investments in your 401(k), from the least risky to the most. Then you can create a portfolio designed to help you meet your goals with the level of risk you’re prepared to tolerate.