Risk is a part of life, and financially, we all need to prepare for it.

There are different types of financial risk, and the strategy for dealing with each is different.

Most people think of risk as losing the principal of their investment — in other words, having an investment be worth less than what was originally invested. The risk of principal loss can happen in business ventures, including investing in the stock market. With diversified stock investments, like mutual funds or exchange trades funds, the risk of principal loss is less than investing in individual stocks. Even with diversified investments, the potential for loss of principal is decreased the longer the money is invested.

Stock market investments aren’t best for money you might need in five years or less.

So you might think you should keep all your money in bank accounts, certificates of deposit and money market funds. These investments don’t generally lose principal, but they sometimes don’t keep up with inflation either, especially after you pay tax on the interest they pay. We’re now in an economic situation in which short-term inflation has increased suddenly, but interest rates are still low; that makes it difficult for a household to live off investments that are entirely in interest-earning accounts.

Liquidity is another risk. If you have most of your net worth in real estate, it has seen a great increase in value lately. But you can’t get to that money immediately.

Diversification of net worth across the stock market, real estate, interest-earning accounts and cash is an approach to protect against multiple risks. How much is in each type of investment depends on your situation. If you’re in your earning years, having at least three to six months of basic living expenses in liquid assets like cash and money market funds is a good way to avoid liquidity risk. If you’re self-employed, having more liquid is a good idea.

A common mistake people make as they go into retirement is to be too concerned about loss of principal, but not considering the risk of future purchasing power. Living a long life can be a great thing, but it produces the risk of outliving financial resources. So having a portion of money invested in growth investments, like stock mutual funds and exchange trades funds, can help money meet retirement needs.

The risks we also need to plan for are the ones we can’t anticipate. Did any of us really anticipate a terrorist attack on our soil on 9/11 or a pandemic that would go on for at least two years? Having enough liquidity to weather these aberrations, as well as the ups and downs that are typical of life and financial markets, is wise. And don’t react financially as if each of life’s downturns is the end of the world as we know it.

Linda Leitz is a certified financial planner. She can be reached at linda@peaceofmindfin.com.

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