The past few weeks have been very trying for our economy. Many people have asked me about the different types of risk they may face by investing their money.
Here are a few of the many different types of risk:
Market risk: This refers to the possibility that an investment will lose value because of a general decline in financial markets, due to one or more economic, political, or other factors.
Inflation risk: Sometimes known as purchasing power risk, this refers to the possibility that prices will rise in the economy as a whole, so your ability to purchase goods and services would decline. Inflation risk is often overlooked by fixed income investors who shun the volatility of the stock market completely.
Interest rate risk: This relates to increases or decreases in prevailing interest rates and the resulting price fluctuation of an investment, particularly bonds. There is an inverse relationship between bond prices and interest rates. As interest rates rise, the price of bonds falls; as interest rates fall, bond prices tend to rise. If you need to sell your bond before maturity, you run the risk of loss of principal if interest rates are higher than when you purchased the bond.
Reinvestment rate risk: This refers to the possibility that you will have to reinvest funds at a lower rate of return than the original investment. Your five-year, 3.75 percent certificate of deposit might mature at a time when a new certificate of deposit pays just 3 percent.
Default risk (credit risk): This refers to the risk that a bond issuer will not be able to pay its bondholders interest or repay principal.
Liquidity risk: This refers to how easily your investments can be converted to cash. Occasionally (and more precisely), the foregoing definition is modified to mean how easily your investments can be converted to cash without significant loss of principal.
Political risk (for those making international investments): This refers to the possibility that changes in foreign governments or politics will adversely affect the financial markets there or the companies you invested in.
Currency risk (for those making international investments): This refers to the possibility that the fluctuating rates of exchange between U.S. and foreign currencies will negatively affect the value of your foreign investment, as measured in U.S. dollars.
The relationship between risk and reward
In general, the more risk you’re willing to take on (whatever type and however defined), the higher your potential returns, as well as potential losses. This proposition is probably familiar and makes sense to most of us. It is simply a fact of life – no sensible person would make a higher-risk, rather than lowerrisk, investment without the prospect of a higher return. That is the tradeoff. Your goal is to maximize returns without taking on an inappropriate level or type of risk.
Understanding your own tolerance for risk
The concept of risk tolerance is twofold. First, it refers to your personal desire to assume risk and comfort level with doing so. This assumes that risk is relative to your own personality and feelings about taking chances. If you find that you can’t sleep at night because you’re worrying about your investments, you may have assumed too much risk. Second, your risk tolerance is affected by your financial ability to cope with the possibility of loss, which is influenced by your age, stage in life, how soon you’ll need the money, your investment objectives, and your financial goals. If you’re investing for retirement and you’re 35 years old, you may be able to endure more risk than someone who is 10 years into retirement, because you have a longer time frame before you will need the money. With 30 years to build a nest egg, your investments have more time to ride out shortterm fluctuations in hopes of a greater long-term return. Travis L. Dobbs, CFP, is the founder of ClearView Financial, which specializes in providing retirement and legacy planning. Mr. Dobbs is Blount County’s only Certified Financial Planner and a proud member of the Million Dollar Round Table. Investment Advisory Services and securities offered through ProEquities, Inc., a registered broker-dealer, and member of NASD & SIPC.
This information is educational in nature and is being provided with the understanding that it is not intended to be interpreted as specific legal or tax advice. Individuals are encouraged to consult with a professional in regards to legal, tax, and/or investment issues.