Know Your Asset Classes

Whether we're pursuing investment performance or seeking safety, we often fail to consider the risks we are taking. Yet every investment, whether it's a highflying stock or a low-yielding certificate of deposit, is risky. The question is, which risks do we want to take?

In any given year, there will be investment losers--and those losers will be determined by the risks that rear their ugly head, so it's a good idea to understand the perils we may face. To that end, consider the three broad investment categories.

Cash investments, such as savings accounts, certificates of deposit and money-market funds, might seem riskless because they shouldn't fluctuate in value. Yet owners of these investments may still lose money once inflation and taxes are figured in.

Over the12 months through May, the consumer price index climbed 1.7%, according to the Bureau of Labor Statistics. Assuming you were in the 25% federal-income tax bracket, you would have needed to collect a 2.3% yield over the same period just to maintain the after-tax, after-inflation value of your money. Unless short-term interest rates rise significantly, it will continue to be tough for cash investors to stay ahead of inflation and taxes.

Bonds can also seem like safe investments. But they too can be risky. If the economic recovery gets back on track, with inflation picking up and demand for borrowed money rising, we may see an increase in the general level of interest rates, including the yield on bonds. That could be bad news for existing bondholders. Bond yields and bond prices move in opposite directions, so that when yields rise, bond prices fall. Bond issuers may also default, threatening both the principal value and the regular interest payments.

Stocks are likely to rise and fall along with the economic outlook. If economic growth is strong, corporations should thrive, their profits should rise and that ought to help the performance of their shares. But if economic growth is weak, corporations may struggle and their shares could tumble in value. Which of these risks will come to pass? Nobody knows for sure--which is why you may want to hedge your bets by including all three types of investments in your portfolio.

Bonds are affected by a number of risks, including fluctuations in interest rates, credit risk and prepayment risk. In general, as prevailing interest rates rise, fixed income securities prices will fall. Bonds face credit risk if a decline in an issuer's credit rating, or creditworthiness, causes a bond's price to decline. High yield bonds are subject to additional risks such as increased risk of default and greater volatility because of the lower credit quality of the issues. Finally, bonds can be subject to prepayment risk. When interest rates fall, an issuer may choose to borrow money at a lower interest rate, while paying off its previously issued bonds. As a consequence, underlying bonds will lose the interest payments from the investment and will be forced to reinvest in a market where prevailing interest rates are lower than when the initial investment was made.

Diversification does not protect against loss or guarantee a profit.

Although a money market fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the fund.

There is no assurance that a mutual fund will achieve its investment objective. Funds are subject to market risk, which is the possibility that the market values of securities owned by the fund will decline and that the value of the shares may therefore be less than what you paid for them.

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