We face risks every day. Take driving to work or to the grocery store. At any moment there could be a crash. You could avoid that risk altogether by working from home or ordering out. You could manage that risk by wearing a seat belt and driving defensively. Or, you could transfer the risk by taking public transit or a car service.
It's the same with financial risks, like the risk of loss you take when you invest, or the risk that inflation will erode the value of your investments, or that you may run out of money in retirement. Some of these risks you can avoid. Others you need to manage. Still others you can transfer. Of course, each route has its advantages and disadvantages. However, understanding this framework can help you make better money choices.
"Understanding how much risk you are willing and able to take is critical before you invest," says Zoey Lin, vice president of Fidelity Financial Solutions. "That's called your risk capacity. It is different for everyone and can vary across the various stages of your life."
Risk capacity has both emotional and financial aspects. For instance, you may have more than enough money to retire, but are not yet emotionally ready to take the risk of living on savings alone. Or you may be emotionally ready to take the leap, but short in terms of savings. In both cases, you have a low risk capacity. On the other hand, you may be emotionally ready and financially prepared. In this case, you have a high risk capacity.
Knowing your personal risk capacity is Step 1. To get started ask yourself these 2 questions:
- How much money could I afford to lose while maintaining my standard of living and fulfilling my financial and personal obligations?
- How much short-term loss am I emotionally prepared to tolerate in exchange for the potential to grow my money over the long term and achieve my investing goals?
Step 2 is putting a plan in place to deal with the inevitable risks that come with investing your hard-earned money at different life stages. Here’s where the Avoid/Manage/Transfer approach can be helpful.
Avoiding investment risk
When you avoid taking risk in investing, you generally accept a lower level of potential return in exchange for a potentially higher level of security and stability. You may remember the days of the local hometown savings bank passbook. It was a safe bet because your savings account was FDIC-insured. You can still invest up to $250,000 in an FDIC-insured savings account, but you will need to accept a very low interest rate in return. After inflation, you are likely to be losing money. In seeking a higher return, you need to accept more risk.
"When people are afraid of taking investment risks, the pursuit of their personal dreams can become more challenging," says Lin. "It's important to remember that the hidden cost of not taking any risks is that you are unable to pay for things in the future like your kid's college expenses, a dream house in 5 to 10 years, or retiring when you actually want to retire."
Read Viewpoints on Fidelity.com: 6 habits of successful investors
Managing investment risk
While you can't control the behavior of the stock market, you may be able to manage the risk of loss through your investment choices. And you can help limit the taxes and fees you pay by the investment products and accounts you choose.
Here are 4 common strategies that financial professionals use to manage risk:
- Fixed income: If you are worried about losses in the stock market, you could manage the level of long-term investment risk by managing the proportions of diversifying asset classes like stocks and bonds. You could also consider high quality fixed income products, like Treasury bonds or investment-grade corporate bonds, that provide a fixed rate of return (assuming the issuer doesn't default). Keep in mind, investing in bonds involves risk, including interest rate risk, inflation risk, credit and default risk, call risk, and liquidity risk.
- Asset allocation: Stocks historically have offered more return but also more risk than bonds. An important way to manage investment risk is to set a mix of stocks, bonds, and short-term investments that is aligned to your investment time frame, financial needs, and comfort with volatility.1
- Asset location: You may be able to reduce federal income taxes by holding highly taxed investments like bonds, stocks held for a year or less, and real estate investment trust funds (REITs), in 401(k)s (if your plan offers them), and IRAs, while leaving investments taxed at relatively low capital gains rates in taxable brokerage accounts. Saving on taxes can help your money grow faster.
- Tax-smart withdrawals in retirement: Knowing what money to withdraw from what account can help you reduce tax liability, and make your savings last longer. If you are already retired, consider withdrawing first from your taxable accounts, thereby maximizing the ability of remaining investments to grow tax-efficiently.
If you're not a DIY investor and don't want the risk of managing your own investment portfolio, you might consider a target risk fund or having a professional manage your portfolio. With a robo advisor, you answer a few questions online, and then a sophisticated algorithm picks an asset mix that fits your time horizon, goals, financial situation, and tolerance for risk. With some robos, you can also get limited individual coaching from a financial advisor.
If you want more personalized help, including asset location and tax management, you might consider a full-service financial advisor. And, of course, in all cases you will want to be sure you are receiving good value for the fees you pay so your money has the potential to grow more.
Read Viewpoints on Fidelity.com: 3 keys: The foundations of investing
Transferring personal and investment risk
The world of insurance is focused on transferring risk from one entity to another.
In addition to health and disability insurance, here are 3 common ways you can transfer personal risk:
- Homeowners insurance lets you transfer some of the risk of home ownership (or, if applicable, renter's insurance) to an insurance company.
- Long-term care insurance helps you transfer the risk of having to pay for high costs associated with an extended care event, such as the cost of residency in a nursing home.
- Umbrella liability insurance is typically added to home and auto coverage to protect against the potential financial fallout of certain types of unforeseen events that lead to property damage or injury.
Investment risk can also be transferred. Here are 2 examples:
- Pensions: If you have a pension, your employer doesn't pay your monthly pension check after you retire; they may transfer the risk to an insurance company that then becomes responsible for paying your monthly pension.
- Income annuities: If you're concerned about running out of money in your retirement, you could transfer the risk of running out of money to an insurance company by purchasing an immediate or deferred income annuity with a lifetime payout option.2 These annuity contracts are designed to deliver a guaranteed stream of lifetime income3 beginning immediately or deferred until a date you select in advance, such as age 70 or even age 85.
Annuities can also be purchased with riders, which can help accomplish a range of goals, including protecting your original principal or providing income in retirement. While offered on fixed and variable annuities,4 these riders are typically combined with variable annuities to provide a guaranteed lifetime withdrawal benefit, a guaranteed minimum accumulation benefit, or even a guaranteed minimum income benefit.
The importance of having a strategy
When the stock market ride gets a little bumpy, Fidelity reminds long-term investors to stick to your plan—to hold your well-diversified portfolio (which reflects an asset mix appropriate for your financial circumstances) and continue to save and to invest those additional savings.
So when it comes to managing risk, it's important to have a strategy. To help mitigate investment risk, seek a combination of ways to avoid, manage, and transfer risk. Consider working with a financial professional to create a disciplined investment plan that suits your individual goals, risk tolerance, and life situation. Lastly, remember, to stick with your plan—even in times of market turbulence or upheaval in your personal life.