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Figure out how risky your investments are by asking these six questions

Figure out how risky your investments are by asking these six questions
Traders work the floor of the New York Stock Exchange. (Getty Images)

How much risk do you take with your nest egg?

For many people the honest answer is, "I'm not entirely sure."

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Heading into what could be a tumultuous period for global markets, having a better sense of how much risk you're facing can assure that you won't be shocked later.

Sudden shocks are what drive investors to make snap decisions they often later regret — like the panicked "long-term" investors who sold all their stocks at the bear market bottom in March 2009.

To get a handle on your risk level, ask yourself these basic questions:

1) Do you know how much you can lose on your bond investments if market interest rates rise?

Bonds can drop in value just as stocks can. It may only seem that bonds are impervious because for most of the last 30 years interest rates have been falling.

If you buy a 10-year bond paying a fixed annual rate of 6%, and one year later new 10-year bonds are paying 5%, your 6% bond is more valuable. So its market value rises.

The flip side: If you buy a bond paying 6% and soon new bonds are paying 7%, your bond's market value falls — because why would someone pay full price for a 6% bond if they can buy a new one paying more?

The example is simplified, but it illustrates the basic risk of loss if market rates rise. And because the Federal Reserve is poised to push rates higher, 2017 could be a rough year for bonds.

How much can you lose? Mutual fund firm Vanguard Group has a handy tool on its website that shows how bond values fluctuate with changes in interest rates. This is the rule of thumb: The longer a bond's term (i.e., the time until it matures and repays principal), the deeper the decline in value if market rates rise.

For bond mutual fund owners, the key number to know is your fund's average maturity or a related measure known as duration. A $1,000 investment in a fund with a relatively short duration of 2.5 years would fall 5%, to $950, if market rates were to rise 2 percentage points. But $1,000 in a fund with a duration of 12 years would tumble 24%, to $760, if rates rose 2 points.

The risk level of longer-term bonds is why many financial advisors are keeping their clients in shorter-term issues now. Michael Yoshikami, head of Destination Wealth Management in Walnut Creek, Calif., says his bond investments are in the three- to five-year duration range. "We're staying in that shorter area," he says.

2) If you plan to hold your bonds forever, do you really “lose”?

You don't actually lose, or gain, on any investment until you sell.

If market rates go up your bond fund could drop, then recoup all of that if rates were to decline again. And whatever happens with the principal value, your fund still is paying you regular interest.

That's why it's important to have a bond strategy. Is the investment meant to be a relatively safe part of your portfolio, offsetting riskier bets like stocks? Or are you trying to earn the highest possible interest rate over time, without worrying about how the market value fluctuates?

3) Is investing in “index” stock funds less risky than investing in actively managed funds?

That depends on your definition of risk.

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With index funds, which simply seek to replicate the performance of a market index such as the Standard & Poor's 500, there's little or no risk of missing a market surge — because the fund manager never tries to time market swings. Whatever the index does is (approximately) what you'll get.

But that also means that, if the index dives, there will be no attempt to soften the blow by, say, holding large amounts of the portfolio in cash. In the 2007-09 market dive, the S&P 500 fell nearly 58% from peak to trough, a horrendous loss that tested many investors' staying power. There were plenty of actively managed stock funds that fell much less than that, sparing their shareholders a lot of grief.

4) If I own shares in a fund, and I stay invested while many other shareholders are bailing, does my risk increase?

In a word, yes.

You might feel great about the securities in the fund and have total faith in your fund manager to ride out a market storm. But if other shareholders are selling out in droves they could be forcing the manager to sell his or her favorite securities to raise cash.

So by staying put, you may find yourself owning a stake in a fund that no longer holds the securities you liked in the first place.

This isn't an argument for bailing out of funds whenever markets slump. But you need to be aware of fund redemption risk in down markets — particularly in funds that go from red hot to cold.

5) Do you know how the value of the dollar affects investments in foreign securities?

When you invest abroad you're making two bets: one on securities and one on currencies. So there are two levels of risk involved.

If you buy a fund that owns Mexican stocks, your return will depend in part on how the stocks perform in Mexico. But the return also will be affected by the level of the peso to the dollar.

If the peso strengthens against the dollar, it takes fewer pesos to equal $1. So even if your fund's stocks stay level in peso terms, they will translate into more dollars.

If the peso weakens against the dollar, however, it takes more pesos to equal $1. If the stocks stay the same in peso terms, they'll be worth fewer dollars when translated.

This year the Mexican stock market is up 11% in peso terms. But because the peso has fallen against the dollar, the iShares MSCI Mexico stock fund is up just 0.3%.

6) Can I lower my overall risk by being diversified?

Yes. This remains one of the central tenets of investing. The better diversified you are among stocks, bonds, cash and other assets, the less likely you are to panic when one or more of those assets takes a hit — which they almost all do, at some point.

Increasingly, financial advisors have looked beyond traditional investments for additional diversification.

Lon Morton, founder of Morton Capital Management in Calabasas, says that rather than own bonds at current low rates he prefers using a portion of clients' assets to make direct loans to borrowers at rates as high as 8.5%. Those borrowers include investors who banks have come to shun since the financial crisis — for example, people who buy properties to fix up for rent or resale.

Early this year Morton invested in energy master limited partnerships, or MLPs, that had collapsed with oil prices, even though the partnerships' businesses were sound. Many MLPs have soared from their winter lows.

"People just have to be patient," Morton says — meaning patient to wait for good investment opportunities, and patient to wait for them to pay off.

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