Risk

In investing, risk is the chance of losing money.
People ordinarily do not take a financial risk unless there is also a chance of making money or being rewarded. If you make an investment that has a real chance of a high return-such as in the equities market-then you are also taking a chance of a low return, or a loss of your money. If you invest in a lower-risk, short-term, fixed-income security-such as a bank savings account-both your risk and your returns will be lower.

How Risk Varies
For example, the historical average monthly return on equities (e.g. stocks) has been a gain of 0.85 percent (10.2 percent annually). At the same time, these returns varied, on average, from a loss of 0.61 percent (7.28 percent annually) to a gain of about 2.6 percent (31.32 percent annually). In other words, $1,000 invested in equities at the beginning of a month could be worth, at the end of the month, as much as $1,026 or as little as $994. At these rates over a year, your $1,000 might grow to $1,313 or decline to $927. [Siegel, Jeremy, Stocks for the Long Run, ©2002, McGraw-Hill.]

Keep in mind that all these returns are averages. Any single stock in any single year could gain or lose a much greater amount. For example, in 2001 Enron lost 95 percent of its value ($1,000 invested in this stock became just $50). In 2002, ICG Communications gained 3400 percent of its value ($1,000 became $35,000)! [Reference: Denver Post, July 23, 2003 ]

Systematic Risk
Risk that the overall equities market will decline is called systematic risk. There is nothing you can do to reduce this risk except to completely avoid investing in equities. But remember that you are giving up the chance of making an average return of as much as 31 percent in a year while avoiding an average possible loss of only 7 percent. Financial professionals would call this a bad trade-off, and they advise most people to invest at least some of their long-term funds in the equities market.

Non-systematic Risk
Risk that any single stock will lose money (or go to zero) is called nonsystematic risk. The good news is that this risk can be minimized. Overall, nonsystematic risk may be diversified by owning several stocks. This is referred to as holding a portfolio, and it relates to the old saying, "Don't put all your eggs in one basket." The chance that a single stock will lose money is offset by the chances of your other stocks making money.

Controlling Risk through Diversification
Equity investors can build a diversified portfolio by buying several stocks that have different risks. This generally means owning stocks of companies in different businesses. Some, like retailers, will do better when the economy is growing and inflation is low. Others, like gold-mining companies, will perform better in times of high inflation or political instability. Another way to diversify is to own stocks of companies that operate in different parts of the world.

Transaction costs
Charges such as brokerage commissions, associated with creating and rebalancing a diversified portfolio can add up and reduce your returns. For example, $2,000 invested at the end of each year for 30 years earning 12 percent per year will grow to $482,665 if there is no sales charge on the investment. A front-end load of 8 percent will bring the value of the same investment to $444,052. In other words, the front-end load (e.g. a sales expense charged on each contribution/deposit) will cost you $38,613! To obtain a diversified portfolio at a lower cost, you can invest through your Thrift Savings Plan, dividend reinvestment plans (DRIPs), and mutual funds.

Asset allocation is another way to diversify overall investment risk. Portions of an investor's assets are invested in equities (both United States and international), fixed income (various types of bonds), commodities (such as gold), and real estate. The percentage invested in each type of asset is determined by your stage in life. Once again, you can achieve an effective asset allocation using mutual funds and real estate investment trusts (REITs).

Dollar cost averaging is the process of purchasing stocks or mutual funds periodically at different market prices. You must commit to investing the same amount of money each time, regardless of what happens to the market price of the stock or mutual fund.

Here's how it works:

• When the price of the stock or mutual fund goes down, you purchase more shares with the same amount of money. It is as if the investment is "on sale."



• When the price of the stock or mutual fund goes up, you purchase fewer shares, but the shares you bought before are now worth more, too!



• Over long periods of time, the average cost of your shares tends to be less than the current market price.

Let's look at an example (refer to the table below):

• Assume that you commit to invest $50 per month in a no-load mutual fund for one year.



• The market price of the fund starts out at $10 per share. At the end of the year it is also $10 per share.



• In months 2 through 5, the market price of the fund declines by $1 per month. The number of shares you buy in each of these months is $50 divided by the market price. Column 5 shows that you are buying more shares with your $50 than in previous months.



• There is no change in price during month 6.



• In months 7 through 10, the market price of the fund increases by $1 per month. The number of shares you buy in each of these months is $50 divided by the market price. Column 5 shows that you are buying fewer shares with your $50 than in previous months.



• In months 11 and 12, the market price of the fund remains unchanged at $10.

Now let's analyze the results.

• The market price of the fund at the end of 12 months is exactly the same as at the beginning of the year, $10 (column 2).



• If, instead of dollar cost averaging, you had invested the entire $600 at the beginning of the year and held on to the fund for 12 months, it would still be worth only $600 at the end of the year.



• Your $50 per month, however, bought more than 5 shares in months 2 through 9 (column 5). Over the 12 months, you bought 74.5635 shares (column 6) for $600, resulting in an average cost per share of $8.05 ($600 ÷ 74.5635 shares; column 7).



• If you sold all of your shares in month 12 at $10, you would receive $745.64 (74.5635 shares × $10 per share), a gain of $145.64 ($745.64 received - $600 cost)! See the table and chart below for an illustration.

Some words of caution:

• Dollar cost averaging requires discipline. You must commit to buying shares even when the market is going down and your emotions tell you to "cut your losses."
• The price movements in the above illustration, while possible, are exaggerated to make a point. Your results will vary.