Investing is a risky business. But despite some of the obvious risks when you invest, you actually face a host of different risks, many of which you may have never even thought of.
Fortunately, there are ways you can get the risks you face as an investor under control. You won't be able to eliminate risk entirely, but you should be able to reach a level of security and comfort that will let you sleep at night.
Let's take a look at five of the risks investors face and how you can address them.
1. Concentration risk.
This one may seem obvious, but many people still like concentrated portfolios because they increase your chance for big gains. Many successful professional investors make concentrated bets on the investing themes they like, and when they're right, their returns are incredible.
Unfortunately, they aren't always right. Bruce Berkowitz's Fairholme Fund is just one example, with the fund having lost 32% in 2011 because of misplaced confidence in Bank of America (NYSE: BAC) and Sears Holdings (Nasdaq: SHLD). The fund has bounced back this year, but it still hasn't come close to recovering all of its losses.
The solution here is simple: Temper your desire for big gains with a more diversified approach that better protects you from losses. That way, you'll never endanger your entire life savings on a single call.
2. Income risk.
One particularly tough thing investors have had to deal with lately is the drop in income from bonds and other fixed-income investments. The low rate environment has pushed many investors toward dividend stocks, high-yield bonds, and other more volatile assets.
But before you jump whole-hog into dividend stocks, you should realize that they too are vulnerable to changing payouts. Telefonica (NYSE: TEF), for instance, recently suspended its dividend for the rest of the year. Meanwhile, Chimera Investment (NYSE: CIM), which many have turned to for its double-digit dividends, cut its payout by half from September 2010 to June 2012.
The best protection is to own a broad range of income-producing assets. Together, they'll give you more income stability even as conditions change in each market.
3. Inflation risk.
Inflation, which I looked at last week, is a pernicious force that sucks the purchasing power out of your money. Slowly but surely, your money loses value, and investments have to grow in order to keep up.
Inflation-indexed bonds are designed to rise along with inflation, but at current rates, they aren't very attractive. The Barclays TIPS Bond (NYSE: TIP) ETF has such strong historical returns because rates have fallen recently. But with a combination of stocks and other assets that tend to see their prices rise when inflation becomes more problematic, you can hold inflation at bay.
4. Tax risk.
Like inflation, taxes also erode your portfolio by forcing you to pay a portion of your income and capital gains. With huge tax increases currently slated to take effect next year, many investors are particularly sensitive to the risk of higher taxes right now.
Fortunately, tax-favored accounts like IRAs and 401(k) employer-sponsored retirement plans can help you avoid or defer taxes. By keeping at least some of your assets in tax-favored accounts, you'll give yourself a better chance to control your overall tax bill and improve your overall investing results.
5. Longevity risk.
Even once you've successfully gathered a big nest egg for retirement, you're still vulnerable to the whims of life expectancy. What may be more than adequate savings for 10 to 15 years of retired living could easily disappear after 20 or 25 years.
Rather than gambling on how long you'll live, one solution is to use lifetime payments to hedge your longevity risk. Social Security is already designed to be a lifelong solution, but you can add to it through immediate annuities that make monthly payments.
Keep risk under wraps
Smart risk management requires constant monitoring, as what may seem to be a safe investment can turn into a scary one in the blink of an eye. But as long as you're aware of the types of risk out there, you can do what you need to do to guard against all of them.
If you need help finding investments to help you protect against risk, we've got some great ideas for you to take a look at. Find out their names in the Motley Fool's special report on stocks that will help you retire rich. Get your free copy today while it lasts!
Also, learn whether Bank of America might make good on Bruce Berkowitz's belief in the bank stock. Check out our premium investment report on Bank of America today.
Tune in next Monday for Dan's next column on retirement, investing, and personal finance. You can follow him on Twitter @DanCaplinger.
