When we discussed the Three Essential Investment Types, we talked about some of the risks that come with each of these investments. That was an overview and worth going back to review these risks. But If you’re going to invest confidently you need to understand broader investment risks. Because investing is rewarding. But it can be a risky business and what you don’t know will hurt you!
As I mentioned in the Three Essentials post, there’s no such thing as a “risk free” investment. Even cash, which can generally be insured by the Federal government isn’t risk free because of inflation (see below). So, everything here is a question of balancing risk and reward. That means you should understand three things to determine where your risk/reward balancing point lies. These are your investment timeline, investing goals and risk tolerance.
There are two broad categories of risk. First, there’s business risk. Business risks are associated with investing in a particular product, company or industry.
The second broad category is market risk. Market risk hits the overall economy or investment markets, knocking down the value of all investments. This is regardless of their individual strengths or weaknesses.
Here’s a look at some of the major types of investment risk, and the type of investments they apply to.
- Management Risk– The risk that a company’s key product line is discontinued, its production costs soar or key personnel changes. All of these examples potentially impact the value of the company or its ability to repay its debts. These risks vary by company and sector.
- Liquidity Risk— The risk that you won’t be able to buy or sell investments quickly. Especially for a price for a price that reflects the value of the investment. Or even worse, that you won’t be able to sell the investment at all because of a lack of buyers in the market.
- Sociopolitical Risk— This is risk related to political and social events such as a terrorist attack, war, pandemic or elections. Events like these, whether real just feared, can affect investor attitudes and outlooks, resulting in big changes in stock prices.
- Volatility (Big shifts in stock price— Stock prices can drop for a variety of reasons, including poor performance of certain companies or concern about the economy. Dips in the stock market tend to be worse than in the bond market.
A word about time. According to a study by the Vanguard Group and based on specific investment periods, if you invested in the stock market for 1 year, your chance of losing money would be greater than 1 in 4. But if you invested for 10 years, that number would drop to about 1 in 25—and after 20 years, to zero. You can read more here. So again, knowing your time horizon, investment goals and risk tolerance are critical in balancing these risks and rewards!
- Credit Risk (or default risk)– The risk that a bond issuer will fail to make interest payments or to pay back your original investment when your bond matures.
- Interest Rate Risk— This is the risk that the value of a bond can swing because of changes in interest rates. As interest rates rise, the price of an existing bond falls and when rates fall, bond prices rise. Think of it this way: if you own a bond paying 2% interest and a new bond pays 3% interest, someone who’s interested in buying your bond would only pay you a portion of its value to break even. Otherwise they’d just buy the new bond paying 3%! Also, this change in the price of bonds works differently with mutual funds (more on these later) and individual bonds.
- Currency Risk. Applies to: International Investments in stocks or bonds — Any change in the exchange rate between two currencies can increase or reduce your investment return. You probably have exposure to currency risk if you own stock in a foreign company or in a large U.S. company with significant foreign sales. For example, as of the writing of this post the American dollar is strong relative to many other currencies around the world. This has the effect of making investments in these countries worth less in U.S. dollars. So, the value of foreign investments are in general down right now. Does this make them bad investments? Not at all! We’ll talk more about foreign investing – and “contrarian investing” – in the future.
- Inflation Risk (or Purchasing Power Risk). Applies mostly to: Cash and Bond Investments— The risk that general increases in the prices of goods and services will reduce the purchasing power of money, and likely negatively impact the value of investments. Inflation and interest rate risks are closely related as interest rates generally go up with inflation. Cash and most bond investments are especially vulnerable to inflation.
- Country Risk. Applies to: International Investments in general— The risk that events in the country in which an investment is made could impact general market sentiment. This can happen when a country overhauls its government, changes its policies, or experiences social unrest or war.
In our next post we’ll talk about different ways that you can start to invest.
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