Risk and return: an introduction

Every investment has risks. Below are definitions of the types of investment risks, in alphabetical order.


 * Business Risk--the measure of risk associated with a particular security. It is also known as unsystematic risk and refers to the risk associated with a specific issuer of a security. A common way to avoid unsystematic risk is to diversify - that is, to buy mutual funds, which hold the securities of many different companies.


 * Call Risk--the risk that a bond issuer, after a decline in interest rates, may redeem a bond early, forcing the bond holder to find a replacement investment that may not pay as well as the original bond.


 * Credit Risk--the risk of default. Holders of bonds face this risk.


 * Currency Risk--the risk due to changes in exchange rate. Investments in currencies other than the one in which you purchase most goods and services are subject to currency risk.


 * Financial Risk--the risk due to the capital structure of a firm. Corporate debt magnifies financial risk.


 * Inflation Risk--the risk that one's investment will not keep pace with inflation. This risk can be mitigated by investing in inflation protected Treasury bonds or other assets thought to rise with inflation.


 * Interest Rate Risk--the risk associated with changes in asset price due to changes in interest rate. Bonds and bond funds face this type of risk. As interest rates rise, prices on existing bonds decline and vice versa.


 * Liquidity Risk--the risk that an asset cannot be sold when desired due to a thin market.


 * Longevity Risk--the risk you will outlive your money.


 * Management Risk--the risk that fund or portfolio managers will under-perform benchmarks due to their management decisions or style. Active funds face this risk. Investors can avoid this risk by selecting index funds.


 * Market Risk--the systematic risk faced by all equity investors due to market volatility. This risk can not be diversified away. This is the type of risk most people are referring to when they casually use the term "risk" with respect to investments, without qualification.


 * Political Risk--the risk to an investment due to changes in the law or political regime. Potential changes in tax law or changes in a country's structure of governance are sources of political risk.


 * Reinvestment Risk--the risk that earnings from current investments will not be reinvested at the same rate of return as current investment yields. Coupon payments from a bond may suffer reinvestment risk if they cannot be reinvested at the same rate as the bond's yield.


 * Under-performance Risk--the risk your portfolio will not provide sufficient returns to meet your goal(s). Stuffing your cash under your mattress is associated with this type of risk.

Asset Allocation
Selecting the appropriate asset allocation (stock to bond ratio) is essential to setting up your portfolio. To minimize risk, you should hold a certain percentage of your portfolio in bonds. If you are unsure of where to start, or would like a comparison with the Bogleheads' recommendations, the Vanguard Investor Questionnaire can assist you in choosing the appropriate asset allocation for your situation.

Caveat: The questionnaire does not take your entire situation into account. Use it as an approximation and proceed from there.