by Michele Cagan, CPA
In the investment world, you'll have to walk a delicate (and very personal) balance between risk and reward. The more uncertain the investment, the greater the risk that your investment won't perform as expected, or even that you'll lose your entire investment. Along with greater investment risk, though, comes an opportunity to earn greater investment returns. If you're uncomfortable with too much risk and seek to minimize it, your trade-off will be lower investment returns (which can be a form of risk in itself). Truthfully, you can't completely eliminate risk. If you don't take any risk at all, you won't be able to earn money through investing.
Investment risk is directly tied to market volatility — the fluctuations in the financial markets that happen constantly over time. The sources of this volatility are many: interest-rate changes, inflation, political consequences, and economic trends can all create combustible market conditions with the power to change a portfolio's performance results in a hurry. Ironically, this volatility, by its very nature, creates the opportunities for economic benefit in our own portfolios, and that is how risk impacts your investments and your investment strategy.
There are many different types of risk, and some are more complicated than others. The 7 risk classifications you'll learn about here are those you'll likely take into consideration as you begin to design your portfolio.
Stock Specific Risk
Any single stock carries a specific amount of risk for the investor. You can minimize this risk by making sure your portfolio is diversified. An investor dabbling in one or two stocks can see his investment wiped out; although it is still possible, the chances of that happening in a well-diversified portfolio are much more slender. (One example would be the event of an overall bear market, as was seen in the early 1990s.) By adding a component of trend analysis to your decision-making process and by keeping an eye on the big picture (global economics and politics, for example), you are better equipped to prevent the kinds of devastating losses that come with an unexpected sharp turn in the markets.
Risk of Passivity and Inflation Rate Risk
People who don't trust the financial markets and who feel more comfortable sticking their money in a bank savings account could end up with less than they expect; that's the heart of passivity risk, losing out on substantial earnings because you did nothing with your money. Since the interest rates on savings accounts cannot keep up with the rate of inflation, they decrease the purchasing power of your investment over time — even if they meet your core investing principle of avoiding risk. For this somewhat paradoxical reason, savings accounts may not always be your safest choice. You may want to consider investments with at least slightly higher returns (like inflation-indexed U.S. Treasury bonds) to help you combat inflation without giving up your sense of security.
A close relative of passivity risk, inflation risk is based upon the expectation of lower purchasing power of each dollar down the road. Typically, stocks are the best investment when you're interested in outpacing inflation, and money-market funds are the least effective in combating inflation.
Market Risk
Market risk is pretty much what it sounds like. Every time you invest money in the financial markets, even via a conservative money-market mutual fund, you're subjecting your money to the risk that the markets will decline or even crash. With market risk, uncertainty due to changes in the overall stock market is caused by global, political, social, or economic events and even by the mood of the investing public. Perhaps the biggest investment risk of all, though, is not subjecting your money to market risk. If you don't put your money to work in the stock market, you won't be able to benefit from the stock market's growth over the years.
Credit Risk
Usually associated with bond investments, credit risk is the possibility that a company, agency, or municipality might not be able to make interest or principal payments on its notes or bonds. The greatest risk of default usually lies with corporate debt: Companies go out of business all the time. On the flip side, there's virtually no credit risk associated with U.S. Treasury-related securities, because they're backed by the full faith and credit of the U.S. government. To measure the financial health of bonds, credit rating agencies like Moody's and Standard & Poor's assign them investment grades. Bonds with an A rating are considered solid, while C-rated bonds are considered unstable.
Currency Risk
Although most commonly considered in international or emerging-market investing, currency risk can occur in any market at any time. This risk comes about due to currency fluctuations affecting the value of foreign investments or profits, or the holdings of U.S. companies with interests overseas. Currency risk necessarily increases in times of geopolitical instability, like those caused by the global threat of terrorism or war.
Interest Rate Risk
When bond interest rates rise, the price of the bonds falls (and vice versa). Fluctuating interest rates have a significant impact on stocks and bonds. Typically, the longer the maturity of the bond, the larger the impact of interest rate risk. But long-term bonds normally pay out higher yields to compensate for the greater risk.
Economic Risk
When the economy slows, corporate profits — and thus stocks — could be hurt. For example, political instability in the Middle East makes investing there a dicey deal at best. This is true even though much of the region is flush with oil, arguably the commodity in greatest demand all over the planet.
