Tuesday, 23 June 2015
Inflation risk, interest rate risk and principal risk
Typically, investors think of 3 basic risk types—inflation risk, interest rate risk, and principal risk.
In fact, there’s no such thing as a riskless investment.
While US Treasuries guarantee a return of your principal, they are subject to inflation risk (the risk that a dollar today may be worth less than a dollar tomorrow).
If you keep cash under your mattress, you not only have inflation risk but you also have risk of fire and theft.
Stocks may potentially reduce inflation risk but have a higher level of capital risk (i.e. if you invest in stocks, you can lose money).
When you substitute one kind of risk, you open yourself up to another.
There are ways to eliminate or at least diminish certain kinds of risks while maintaining long-term objectives.
An investor could simply not invest as much in vehicles that have risk to principal, like stocks.
Or, they could allocate more money to principal-protected investments.
Since investment returns are typically a function of how much risk you are willing to assume, the lower the risk, the lower the returns.
That said, there are investments designed to give an investor some exposure to the stock market, while guaranteeing a stream of income during retirement. These typically have liquidity risk. In other words, you might not be able to access your money for a certain period of time.