Know your investment risks — and how to respond

When you invest, you take some risks. While you can’t totally avoid these risks, you can take steps to help reduce their impact and increase your comfort level. And the more comfortable you are with your investments, the easier it will be to follow a long-term strategy that can help you meet your goals.

Let’s look at the most common types of risk related to investing, along with some suggestions on helping to reduce these risks:

Losing principal: his type of risk is most closely associated with investing. For example, when you purchase a stock, you know that its value could go up or down. If it drops below your purchase price, and you then sell your shares, you will lose some of your principal.

Your response: You can’t eliminate the risk of losing principal, but by owning a mix of stocks, bonds, government securities and other types of investments, you can help reduce the impact of volatility on your portfolio. Keep in mind, though, that diversification, by itself, can’t guarantee a profit or protect against loss.

Losing value when interest rates change: This type of risk primarily affects fixed-income investments, such as bonds. If you purchase a bond that pays, say, a 4 percent interest rate, and the market rate goes up to 5 percent, then the value of your bond will drop because no one will be willing to pay you the full price for it when newer, higher-yielding bonds are available.

Your response: You can combat, or even ignore, interest rate risk by holding your bonds until they mature. By doing so, you’ll get your full principal back, provided the issuer doesn’t default, and you’ll continue to receive regular interest payments unless the bonds are “called,” or repurchased by the issuer. (You can help protect against this by purchasing bonds that have some degree of “call protection” and by owning bonds with different maturities.)

Losing purchasing power: This risk largely applies to fixed-rate investments such as certificates of deposit (CDs). To illustrate: If you purchase a CD that pays 2 percent, and the inflation rate is 3 percent, you are actually losing purchasing power.

Your response: Despite their vulnerability to inflation, CDs can offer you some valuable benefits, such as preservation of principal. Yet if you are concerned about fighting inflation, you may want to look for investments than have the potential to offer rising income, such as dividend-paying stocks. In fact, you can find stocks that have increased their dividends for many consecutive years. (Be aware, though, that companies can reduce or eliminate dividends at any time. Also, an investment in stocks fluctuates, and you could lose your principal.

What is a CD Account and how does it work

You’ve probably heard of a CD account before but you don’t really know what it is.  A CD account, also called a certificate of deposit account, is a loan that you make to a bank for a fixed amount of time.  Certificate of Deposit accounts are known to be one of the safest investment vehicles.  In return for your loan, a bank will give you interest on your loan.  That is where the term CD account comes from,  you get a certificate of deposit once you agree to loan the bank the money.  The interest rate of CD accounts increase with the amount of time you agree to loan the bank.  The interest rates of CD accounts are usually higher than the interest you will receive from your checking or savings account.  Most CD accounts have terms from 3 months to up to 10 years and are insured by the FDIC up to $250,000.  Along with having your money in a CD account longer for higher interest rates, you can also choose to put more money in your CD account to receive higher interest rates.

Many experienced CD account investors recommend the CD laddering strategy when investing in certificate of deposit accounts.  The laddering strategy is a lot like the average-cost strategy of stock investing.  The point of the CD laddering strategy is to not put all your money into one CD account but rather you spread your money into different time horizons and reinvest the CD accounts that mature first.

Here’s how laddering CDs works:

You go to the bank with $50,000 and spread your investment into 5 equal CD accounts.  You will have $10,000 in a 1 year CD, a 2 year CD, a 3 year CD, a 4 year CD, and a 5 year CD.  Each year is essentially a step up the ladder.  When the first CD account comes to maturity, you reinvest that money in a new five-year CD because by that time all your CD accounts will have matured one year—meaning your old 5 year CD is now a 4 year CD.  And rinse and repeat—meaning as each and every one of your CD accounts matures, you reinvest it in a new 5 year CD.