Navigating a ship through rocky waters takes skill but once you’re past the rough patches, it’s smooth sailing again. As an investor, you also must prepare for obstacles that can cross your path. Investment risks can take many forms, interrupting the calm with an occasional storm. Imagining different ‘what if’ scenarios helps with creating a risk management contingency plan.
1. What if inflation increases?
Inflation is a sustained rise in the price of goods and services over time. In other words, it means the things you buy get more expensive. If the returns on your investments don’t increase at a similar pace, your purchasing power can erode.
Managing inflation risk starts with knowing how to potentially hedge against it. That means choosing investments that are less likely to be negatively affected by rising prices. Some common ones include real estate, gold and commodities — because their value can remain stable or increase during periods of higher inflation. Treasury Inflation-Protected Securities (TIPS) are another possibility since the interest rate they pay adjusts with changing inflation rates.
You might also dial back risk in the near term by focusing on investments or accounts that are less sensitive to inflation, for instance, by investing in long-term bonds or depositing funds in a Certificate of Deposit (CD).
2. What if the market becomes volatile?
When the market experiences volatility, prices increase or decrease more frequently. This is a natural part of how the market works, and in fact, you need prices to change if you want to make a profit on investments. It’s how a basic buy low, sell high strategy works.
While you can’t escape volatility completely, you can help manage it by:
- Diversifying your portfolio to include a mix of securities with different risk profiles
- Choosing investments that aren’t highly correlated with one another (meaning they each react differently to market volatility)
- Avoiding herd mentality or emotional investing that might tempt you to sell when everyone else is selling or buy when everyone else is buying
- Leveraging dollar-cost averaging
3. What if there’s an interest rate hike?
The Federal Reserve may choose to raise interest rates if the economy appears to be in danger of overheating. Higher rates can make it more expensive for borrowers to get loans or lines of credit.
Managing risk during changing rate environments means understanding how rate hikes can affect different investments. When interest rates rise, for instance, bond prices typically fall. That can affect bond yields, especially for bonds with longer maturities. So, investing in shorter-term bonds when rates go up could be an effective risk mitigation strategy.
With stocks, some sectors may outperform others during a rising rate environment. Consumer staples, for example, may do well despite higher rates since people still need to spend money on basic necessities. Considering a sector rotation approach could help to keep risk in check through periods of rising, then falling interest rates.
4. What if I lose my job?
A job loss might leave you wondering if you should continue investing or even pull your money out of the market.
Continuing to invest while you’re looking for your next job can help you stay on track with your financial goals. If you have dividend-paying stocks in your portfolio, they could be a source of income until you have a paycheck coming in again. (This assumes that you can afford to invest money if your income drops temporarily, which might not be possible for many people.)
Depending on our situation, you may take money from your investment or retirement accounts. But take note: You will miss out on the power of compounding returns, which can mean less wealth in the long run.
Cashing out investments also has tax implications. If you sell stocks or other investments at a profit in a taxable brokerage account, you’ll trigger capital gains tax. Early withdrawals from a 401(k) or Individual Retirement Account (IRA), meanwhile, can result in tax penalties. These risks may not be worth it, if you have other potential financial resources.
5. What if I have a financial emergency?
These can throw a wrinkle into your investing plans. If you need to make a major home repair, for example, you may need to put investing on hold temporarily to pay for the fix.
Building an emergency fund can allow you to continue investing even when a curveball comes your way. It could help with managing risk by ensuring that you don’t have to sell off investments to cover cash flow gaps.
You can’t avoid risk, but you can plan for it.
Risk is something you must consider when investing. Ask yourself how much you’re comfortable taking and how much you need to take to reach your financial goals. Once you know where the sweet spot between your risk tolerance and risk capacity lies, you can create strategies to reach your investment goals. Think of risk management as your personal compass for steering your financial ship through changing tides.
Choose how you want to invest.