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Understanding Risk

When you begin saving for retirement, how do you go about protecting your investments against market risk? Most investors allocate their money among different types of investments to protect their money, combining growth investments such as stocks with less risky bonds and money market instruments. Some investors, however, figure that if some combination of stocks and money markets is good, then a portfolio dominated by lowest-risk assets must be even better.

If you're of the latter frame of mind, beware! Eliminating market risk doesn't take away all risk from your retirement savings plan. Risk comes in a variety of forms; the subtleties are the stuff that investment professionals discuss for hours. But the greatest risk in a retirement savings plan is not the day-to-day changes in the value of your investments. The greatest risk of all is not meeting your financial retirement goals at retirement.

Here are the different faces of investment risk and a brief description of each.

Market risk--This is the risk most investors recognize. Stocks typically outperform other investments over the long haul. Time is the key; allowing investments to ride out the highs and the lows that are common in the stock market. But remember, past performance of an investment does not guarantee future results. Yes, stocks historically have had a higher rate of return than bonds or money markets over time, but this return is not guaranteed.

Credit risk--Fixed income securities, such as bonds, are generally considered to be more stable than stocks. However, over the past 25 years, bonds have been as volatile as stocks with less reward. There's also the bond's rating; its credit-worthiness can affect its performance. The lower a bond's rating or quality, the higher the potential return, but the higher the risk. Bonds can also default and bond holders can lose their principal unless the bond is insured. Here are the different faces of investment risk and a brief description of each.

Inflation risk--Uncle Sam guarantees the bonds it issues. Certificates of Deposit (CDs) issued by banks are also federally insured (the basic insured amount of a depositor is $100,000), but neither of these investments mean an elimination of all risk. Inflation, when it matches or exceeds your investment return, will play havoc with your retirement nest egg. And while fixed income investments will often guarantee your principal and a predetermined return on your money, they can’t ensure that you’ll keep pace with inflation. Bonds, for example, typically offer a lower rate of return as interest rates drop.

Remember, a well thought out retirement plan includes a projected rate of return and a projected cost of living during your retirement based on the amount of savings you will need to achieve your retirement income goals. When either is underestimated, you'll have fewer real dollars than anticipated. For this reason more than any other, experienced investors always diversify and allocate their dollars into different types of assets to meet these different risks. Because no one investment can do everything, a well-diversified portfolio might include stocks to protect against the effects of inflation, money markets and other cash instruments to provide certainty, and bonds offer a combination of both. When considering risk in a retirement savings strategy, selecting inappropriate, low-risk investments can undermine retirement savings objectives as readily as a portfolio of volatile investments.

Wise investors know that only one risk matters when retirement approaches--not having enough savings to meet their income needs. Through diversifying and allocating savings during the different stages of your working life, you can feel confident that your retirement goals can become a reality.

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