Few terms in personal finance are as important, or used as frequently, as "risk." Nevertheless, few terms are as imprecisely defined. Every investment carries some degree of risk, including the possible loss of principal, and there can be no guarantee that any investment strategy will be successful. That's why it makes sense to understand the kinds of risk as well as the extent of risk that you choose to take, and to learn ways to manage it.

What makes volatility risky?

Suppose that you had invested $10,000 in each of two mutual funds 20 years ago, and that both funds produced average annual returns of 10%. Imagine further that one of these hypothetical funds, Steady Freddy, returned exactly 10% every single year.¹ The annual return of the second fund, Jekyll & Hyde, alternated—5% one year, 15% the next, 5% again in the third year, and so on. What would these two investments be worth at the end of the 20 years?

It seems obvious that if the average annual returns of two investments are identical, their final values will be, too. But this is a case where intuition is wrong. If you plot the 20-year investment returns in this example, you'll see that Steady Freddy's final value is over $2,000 more than that from the variable returns of Jekyll & Hyde. The shortfall gets much worse if you widen the annual variations. This example illustrates one of the effects of investment price volatility: Short-term fluctuations in returns are a drag on long-term growth.

Although past performance is no guarantee of future results, historically the negative effect of short-term price fluctuations has been reduced by holding investments over longer periods. But counting on a longer holding period means that some additional planning is called for. You should not invest funds that will soon be needed into a volatile investment. Otherwise, you might be forced to sell the investment to raise cash at a time when the investment is at a loss.

Other types of risk

While there are many different types of risk, below are a few examples:

• Market risk: This refers to the possibility that an investment will lose value because of a general decline in financial markets, due to one or more economic, political or other factors.
• Inflation risk: Sometimes known as purchasing power risk, this refers to the possibility that prices will rise in the economy as a whole, so your ability to purchase goods and services would decline. Inflation risk is often overlooked by fixed income investors who shun the volatility of the stock market completely.
• Interest rate risk: This relates to increases or decreases in prevailing interest rates and the resulting price fluctuation of an investment, particularly bonds. There is an inverse relationship between bond prices and interest rates. As interest rates rise, the price of bonds falls; as interest rates fall, bond prices tend to rise. If you need to sell your bond before it matures and your principal is returned, you run the risk of loss of principal if interest rates are higher than when you purchased the bond.
• Liquidity risk: This refers to how easily your investments can be converted to cash. Occasionally (and more precisely), the foregoing definition is modified to mean how easily your investments can be converted to cash without significant loss of principal.

The relationship between risk and reward

In general, the more risk you're willing to take on (whatever type and however defined), the higher your potential returns, as well as potential losses. This proposition is probably familiar and makes sense to most of us. It is simply a fact of life—no sensible person would make a higher-risk, rather than lower-risk, investment without the prospect of receiving a higher return. That is the tradeoff. Your goal is to maximize returns without taking on an inappropriate level or type of risk.

Understanding your own tolerance for risk

The concept of risk tolerance is twofold. First, it refers to your personal desire to assume risk and your comfort level with doing so. This assumes that risk is relative to your own personality and feelings about taking chances. If you find that you can't sleep at night because you're worrying about your investments, you may have assumed too much risk. Second, your risk tolerance is affected by your financial ability to cope with the possibility of loss, which is influenced by your age, stage in life, how soon you'll need the money, your investment objectives and your financial goals.

Reducing risk through diversification

Don't put all your eggs in one basket. You can potentially help offset the risk of any one investment by spreading your money among several asset classes. Diversification strategies take advantage of the fact that forces in the markets do not normally influence all types or classes of investment assets at the same time or in the same way (though there are often short-term exceptions). Swings in overall portfolio return can potentially be moderated by diversifying your investments among assets that are not highly correlated. In a slowing economy, for example, stock prices might be going down or sideways, but if interest rates are falling at the same time, the price of bonds likely would rise. Diversification cannot guarantee a profit or ensure against a potential loss, but it can help you manage the level and types of risk you face.

In addition to diversifying among asset classes, you can diversify within an asset class. For example, the stocks of large, well-established companies may behave somewhat differently than stocks of small companies that are growing rapidly but that also may be more volatile. A bond investor can diversify among Treasury securities, more risky corporate securities, and municipal bonds, to name a few. Diversifying within an asset class may help reduce the impact on your portfolio of any one particular type of stock, bond, or mutual fund.

Evaluating risk

You should be fully informed about an investment product before making an investment decision. You can review available sources of information, including prospectuses, information in third-party business and financial publications and websites, as well as annual and other periodic financial reports. The Securities and Exchange Commission (SEC) also can supply information.

Busey Wealth Management provides second-to-none comprehensive resources and personalized solutions to help you reach your goals. No matter where you are in life, our advisors are dedicated to helping you enhance and preserve your financial future. To learn more, visit busey.com/wealth-management.

¹ This is a hypothetical example and does not reflect the performance of any specific investment. This example assumes the reinvestment of all earnings and does not consider taxes or transaction costs.

This is not intended to provide legal, tax or accounting advice. Any statement contained in this communication concerning U.S. tax matters is not intended or written to be used, and cannot be used, for the purpose of avoiding penalties imposed on the relevant taxpayer. Clients should obtain their own independent tax advice based on their particular circumstances.

This material is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities.

This presentation is for general information purposes only. It does not take into account the particular investment objectives, restrictions, tax and financial situation or other needs of any specific client.

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