When you think of investment risk, what comes to mind? For most people, it is the potential of losing their money. You know the drill – you invest $10,000 and almost immediately it plummets to $8,000.
Even though this type of risk is the most common kind, in some cases it is not the most dangerous. There are many types of risk when it comes to your investments, and understanding each one of them and how they affect your portfolio is important.
PRINCIPAL RISK: This is when you lose your original investment. See the above example (investing 10-large and losing 2 grand). The potential loss of principal varies depending on the investment, but a general rule of thumb is that the more principal risk an investment has, the higher potential return. Your advisor can help you determine your tolerance for this type of risk, as it will help determine which investments are suitable for you.
INFLATION RISK: Today a gallon of milk costs nearly $4, up from 82 cents in 1950. A first class postage stamp was $.06 in 1970, but today runs $.44. The consumer price index has increased at an average rate of 3.1% per year since 1926. What does all of this mean? Simply put, your investments need to earn more than 3% per year just to “tread water.”
CREDIT RISK: This is the risk that a company or government will be unable to pay its obligations to you. If you were to buy a corporate bond issued by Company A, and they are unable to pay you the promised interest rate, they have defaulted on the bond. If the company continues to struggle, they could possibly go out of business….to assume this type of risk is to assume credit risk.
REINVESTMENT RISK: In 2001, the 10-year treasury bond yield was 5.14%. If you had purchased that bond and it matured today (as of this writing), your new yield is 3.43%. Assuming a $100,000 investment, your annual income just dropped from $5,140 to $3,430 due to reinvestment risk. Or, the risk that interest rates will be lower when your investment matures and it is time to reinvest.
POLITICAL RISK: What if you purchased several individual stocks that pay high dividends (taxed at only 15%), and Congress then decides to double the tax rate on dividends? Hello, political risk. A more likely example would be if a country completely changed its policies regarding investments. This would more than likely have a far reaching impact.
LIQUIDITY RISK: The liquidity of an investment is its ability to be sold for cash at some point in the future. If an investment is highly liquid, that means it is easy to sell. If an investor purchases an illiquid investment, they need to understand that it will be difficult to realize their investment gains should the asset appreciate. This risk can be significant if something NEEDS to be sold, and there is not a buyer. You know…the house is listed at $325,000, nobody is biting, and that second mortgage payment is eating you alive. Time to cut the price, yet again.
REGULATION RISK: This is similar to political risk, except that instead of a country changing the rules, it could be a regulatory agency like FINRA. If you are holding an investment whose value has remained high due to a favorable environment, and FINRA changes the environment, your investment may potentially have additional risk.
OPPORTUNITY RISK: Good old fashioned procrastination is usually when opportunity risk rears its ugly head. Investment A looks like a good idea for Mr. Roman, so the Broker calls Mrs. Roman and pitches her on the idea. She wants to discuss the investment with her husband, so she tells the Broker she will call him back. They discuss it and decide to pull the trigger, only to find out that the investment is SOLD OUT by the time they call back. Opportunity is gone.
INTEREST RATE RISK: This type of risk is mainly applicable to fixed income investments. If a bond is purchased with a 3% interest rate, and then the interest rates in the economy skyrocket, the current value of the bond will decline. The bondholder has locked in an inferior rate, so if they had to sell their bond before maturity, they would receive less than par value in return. Often times, interest rate risk is misunderstood….some people do not understand how they can lose money in bonds. It can happen, and the reason it can is interest rate risk.
COMPANY RISK: This is the risk that is associated with a single company, and this cannot be eliminated. What if you bought stock in a Company 1 week before the CEO died in a plane crash? Or, the investment decision occurred a month before the corporation announced that they were being investigated by the SEC for fraud…think that would matter?
Although there are other types of risks, these are the major ones that should be understood. Please keep one thing in mind when considering an investment: NO investment is risk free. NONE OF THEM. Obviously, some have more types of risks than others, and the ones with more risk typically have the potential for a higher return.
But, please remember that NO. INVESTMENT. IS. RISK. FREE.