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All of us know that in life there are risks. Examples of everyday risks
common to all of us include traffic accidents, contracting a serious
disease, slipping on icy pavement or changes in the economy. The
list of potential risks is limited only by one's imagination. In the
area of investing, there are also various types of potential risks,
and discussing them is the purpose of this feature.
Each type of investment has different risks associated with it. A
wise investor should be aware of those risks before investing in a
particular financial product. Following are important risks that you
potentially will face, as you progress along your path toward
financial security.
Types of Investment Risk
-
Risk from lack of portfolio diversification - Most of us is
aware of the risk of keeping 'all of our eggs in one basket.' If
all or a large percentage of your investment assets are in one
type of investment, such as your employer's stock or long-term
U.S. Treasury bonds, you are unprotected if they decline
significantly in value. That's why investment professionals
recommend portfolio diversification. For example, rather than
buying individual stocks of a few companies, invest in a stock
mutual fund that provides you ownership of a small portion of the
fund's overall portfolio of many different stocks.
-
Credit risk - Also known as repayment risk, this is the
risk that you will lose the amount you invested. For example, a
friend or relative recommends you buy stock in a new company and
you invest $100. Subsequently, the company goes out of business
and your investment is worthless.
-
Inflation risk - Inflation steadily erodes the value of your
hard-earned dollars. For example, you buy a U.S. Treasury bond for
$1,000 that matures in 15 years. When you get your $1,000 back 15
years from now, the $1,000 will no longer buy what it did 15 years
earlier. But the chance of large fluctuations is why inflation is so harmful to retirees on fixed
incomes.
-
Market risk - This risk occurs when the value of your
investment declines in value rather than increases as hoped for.
It's common knowledge that stock values, for example, fluctuate
regularly and, on occasion, plummet for various reasons. For
example, many of you will recall that day in October 1987 when the
Dow Jones Industrial Average plunged 508 points to 1,738.74 - a
22.6% drop - and again ten years later in October 1997 when it
dropped 554.26 points to 7,161.15 in a single day also - a 7.2%
drop.(1) Thus, investing in the stock market should involve a
long-term plan to consider unexpected declines. Fortunately for
stock market investors, wild swings like that are not a frequent
occurrence. This is why investing in stocks with money you will
soon need access to is not a wise idea.
-
Liquidity risk - There may be times in our lives when we need
to sell something earlier than we anticipated. For example, you
own a rental property that you had planned to hold on to as a
source of monthly retirement income from the rental payments.
Unexpectedly, your spouse becomes seriously ill and you need to
sell the property to raise needed cash even though the market for
rental properties has temporarily slowed down due to the economy
being in recession. As a result, you sell at an artificially low
price.
-
Interest rate risk - You may remember the years of high
inflation during the late 1970s and early 1980s when the prime
rate reached above 21% and other interest rates on CDs and
mortgages also rose to double digits before rates declined during
the subsequent national recession. If you had bought a
fixed-interest rate investment such as a bond prior to the sharp
rise in interest rates back then, the value of your investment
plunged. On the other hand, if you bought a bond paying those high
rates of interest at that time, you could have later sold the bond
for a handsome profit.
-
Risk from being too conservative - Have you ever noticed how
our anxiety levels can rise substantially when the stock market
plummets? Many of us have personally experienced that anxiety. To
avoid that stress, some investors play it too safe. They invest in
very conservative investments such as CDs, money market accounts
and U.S. Treasury bills, notes and bonds. While very safe, these
investments also pay relatively low rates of interest. Thus, if
you are saving for retirement, for college education or some other
long-term goal, you run the risk of accumulating too little
especially when you consider the effect of inflation on your cost
of living. By the time you realize you have been too conservative,
it may be very difficult or too late to recover.
-
Currency risk - For the average American investor, this risk
category does not pose the same threat as the previous risk
categories because your investments will typically be in what are
known as dollar-denominated investments such as stocks and bonds
of U.S. companies. However, if you own foreign investments such as
stock of a Japanese company, your dollars were essentially
converted to yen to accomplish the purchase. If the value of the
yen declines against the U.S. dollar, your Japanese stock will be
worth less. Conversely, if the yen gains value against the dollar,
the stock will be worth more. Fluctuations in worldwide currency
values occur on an ongoing basis due to economic and political
conditions in the United States and foreign nations. As a result,
your Japanese company could be doing very well financially but you
could be handed a significant loss or gain because of currency
fluctuations.
One final comment. There is no truly riskless investment.
Overall risk to your portfolio can be minimized if you understand an
investment's inherent risks, before you invest and you are using an
appropriate investment strategy such as portfolio diversification.
Endnotes:
(1) Jennifer Oldham, “A History of the Dow,” Los Angeles Times, March 30, 1999, p. C6.
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