How to Understand and Manage Investing Risk

By Justin Pritchard, CFP®

When you save money for the future, it might make sense to take some risk with that money. But what does that really mean? And why would you consider putting your hard-earned money—or your life savings—at risk?

Some people handle their finances without putting much thought into investment risk. Whether they avoid it altogether or they blindly take risks, the outcome can be unfortunate. But when you make an intentional decision about how to manage your money, you improve the chances of things going the way you want.

On this page:

  • What is risk?
  • 2 Ways to think about risk
  • 6 Ways to manage investment risks

What Is Investing Risk?

When it comes to your finances, risk is an unknown future outcome: You don’t know if your assets will gain or lose value. There’s also the question of how fast your account values might move, and exactly when any movements might happen.

For most people, the primary concern is about losses: Investing risk is the risk of losing money in the markets. But you also face the risk of positive returns that are insufficient to help you reach financial goals.

Why Take Risk?

We often crave certainty, so why deal with unknowns? The primary benefit of taking risk is that you can potentially get relatively high returns. Your money might grow faster if you invest and take calculated risks (compared to risk-free investments like savings accounts and CDs). But you can’t ignore the risk part—you might lose money or you might underperform.

2 Ways to Think About Risk

To get clarity on which investment risks to take (or avoid), it may be helpful to view the topic from different angles.

1. Willingness to Take Risk

Start with the question of comfort: Are you willing to put your money into things that might lose value or that might gain value at an unpredictable rate? This question is about your temperament and your tolerance for ups and downs that might come with investing. 

There’s a spectrum that ranges from a willingness to gamble to a strong desire for security—and everything in between. Some people feel a high level of discomfort and anxiety around risk. That’s okay, and it’s important to acknowledge. That’s because you may find it unbearable when things are going badly, and you may be tempted to take action at what turns out to be a bad time.

You don’t necessarily have to eliminate all risk, even if you have a low tolerance for risk. Instead, you can be mindful about how you take risks and manage your risks in a way that increases your comfort. We’ll discuss some of those strategies below.

An easy way to understand your risk tolerance is to take a risk questionnaire. I like to use a short quiz that’s developed by psychologists, and going through the exercise can help you understand how you feel about risk.

2. Need to Take Risk

Understanding your risk personality is important, but you need more information to make smart decisions about investment risks. It’s wise to evaluate whether or not risk makes sense financially.

Let’s look at two oversimplified examples.

A 22-year-old who is just starting to save for retirement in 40 years might benefit from taking risk. If we assume that by doing so the investor will get higher returns than risk-free asses like bank accounts would pay (no guarantees, of course), those higher returns would be helpful. If the investor wants to avoid risk altogether, that’s fine, but she’ll need to save substantially more, which might mean working longer or spending less during her working years (which is no fun).

For example:

  • If she saves $6,000 per year earning 6% per year, she’ll have $928,572 after 40 years.
  • If she saves the same amount but earns 2% per year, she’ll have $362,412.

The higher the return, the more she’ll have, and taking some investment risk may be the only way for her to fund a secure retirement.

But things might look different for a 60-year old who has substantial assets. In fact, let’s assume she has more than enough saved up, given some assumptions about the future and her Social Security benefits. In this case, why take big risks? She has little to gain, and a lot to lose. By taking unnecessary chances, she could ruin a good thing and have to make drastic cuts or go back to work.

How to Manage Investing Risks

For many people, some level of risk is appropriate. But it’s not an all-or-none thing. You can take a reasonable amount of risk while taking steps to avoid catastrophic losses. Unless you keep all of your funds in government-guaranteed bank or credit union accounts (and stay below the maximum limits), you can’t eliminate risk. But the steps below can potentially help.

Diversification

The classic investment management strategy is diversification. By putting your eggs in a variety of baskets, you can reduce the chances of seeing everything lose value at the same time—maybe. But in the 2007-2008 financial crisis, losses were widespread, and these events can happen.

Diversification is easy to accomplish with a well-designed investment strategy. You can also use single-fund solutions, such as asset allocation funds or target-date funds that spread your money out. Be sure to research exactly how those products work and evaluate how much risk they take before investing.

Time Segmentation (Bucketing)

If you’re taking retirement income, you can use different “buckets” to diversify your money and manage risk. With that approach, your first bucket might be money you plan to spend soon—within the next three to five years. That money would generally be in safe vehicles like bank accounts or high-quality short-term bonds. The following bucket might take moderate risks, and the hope is that the money will grow. 

You’ll replenish the first bucket with funds from the second bucket. Finally, a third bucket might consist of assets you don’t plan to touch for at least ten years. That segment can potentially take more risk, with the hope (but no guarantees, of course) that you’ll have time to recover if markets crash, and you could be rewarded for taking more risk. Over time, you’d refill the second bucket with funds from the third bucket.

Transfer Risk

Instead of accepting all of the risks of investing, you can transfer some risk to an insurance company. When doing so, you may be able to limit or avoid losses, and you might have some exposure to market growth. 

As with any type of insurance, you pay a price when you use an insurer to reduce risk. In some cases, the cost is simply a variety of fees you pay inside of an annuity. But in other cases, the cost is less visible. You might lose flexibility or be forced to accept tradeoffs that come with the product you’re buying (and in many cases, those are hard to understand).

Avoiding Risk

If you don’t need to take risk or you can’t stomach investment risks, avoiding risk is an option. You can keep funds in bank and credit union accounts, and be mindful of FDIC and NCUSIF insurance limits—just in case your bank fails.

A potential tradeoff of avoiding risk is the risk of inflation. If prices rise over time, your funds might not grow at a rate that allows you to keep up with inflation, and you may lose purchasing power. But if you run the numbers and find that you don’t really need to take risk, this can be an informed decision you make with the hopes of all going well.

Hedge Risks

Some investment strategies and tools help you reduce risk. Similar to using insurance, you can hedge risk with things like options, structured products, or “buffered” strategies that aim to limit your losses while providing upside potential. Those strategies all have pros and cons. They might not work as expected, and as with insurance, you typically pay a price (or pay in several ways) for any benefits. Other risks may also exist when you use those products, so it’s critical to read disclosures carefully before you buy anything.

Consider Time Horizon

How a moderate investment mix performed historically - past performance does not indicate future results
Rolling returns are “slices” of history (every 10 years, for example).

If you have a long time before you need to use funds, sensible market risks could help you grow your money. Investing with a short time horizon is gambling, but giving markets time to recover, has historically been a decent approach. Granted, the future might not unfold like the past did. But if we look at longer time horizons versus short timeframes, returns have been higher for stock market investments compared to lower-risk vehicles. Plus, the variation in returns tended to compress, as shown in the chart above.

What Next?

It’s time to make serious decisions about how you manage your money. Evaluate why you’re saving money and what you hope to use the funds for. Estimate when you’ll withdraw funds, and assess your level of comfort with taking risk. Then, weigh the tradeoffs: How do your feel about paying for insurance or hedging strategies, relying on diversification, riding things out over long time periods, and dealing with inflation? 

With that information, you’re better prepared to make smart decisions about how to invest.