Investing is full of ways to make money. Yet, despite what you may have heard, there are no safe investments. Anything you put your money into has risks. Whether its stocks, bonds, real estate, a business, and even your savings account, it pays to understand the different types of investment risk involved in anything before putting your money to work.
Investment risk is simply the possibility of real losses. It’s often confused with volatility, which is the daily swings in asset prices. While those swings can be unnerving at times, the concern is when prices swing down and stay down. This is because of one or more types of investment risks covered below has become a reality.
You hear stories how a soda used to cost a nickel. Or how a dollar today is worth more than a dollar tomorrow. That’s inflation at work, silently eroding your purchasing power. That includes your invested money. If you’re investments aren’t keeping up with the inflation rate, you’re losing purchasing power, and money. That’s the heart of inflation risk, you can find out more here.
Interest Rate Risk
The best example of interest rate risk is in the dynamic of bond prices and yields, but it’s found with any interest bearing assets. This includes assets like your savings account, loans, REITs, and preferred stock.
As interest rates change over time, bond prices adjust according, and in the opposite direction. Any big moves in interest rates will have a bigger effect on bond prices. A move in the wrong direction would lead to a big loss. Read more about interest rate risk.
Anytime you invest in bonds there’s a chance the company or government will miss a debt payment or default entirely. The likelihood of that is the default risk or credit risk, which was a factor in the recent housing crisis. Simply, investors demand a higher interest rate from companies with a suspect credit and earnings history. It’s no different from getting a loan from a bank.
Supply and demand drive’s prices on investments. Liquidity is a measure of how easy it is to buy and sell your investments. Most of the time liquidity risk is low. There’s usually a big market for most stocks, bonds, and funds. Sometimes it’s not the case. Real estate is a perfect example. After the housing crisis, selling a house was nearly impossible. When there are no buyers, its impossible to sell. Of course, the opposite is true. Generally, the riskier and more unusual investments are less liquid.
Better known as a lack of diversification, concentration risk is when you have too many eggs in one basket. The most likely offenders are employees and their company’s stock. Very often you’ll see this as part of a 401k plan or employee stock options plan and it can be a great addition to any benefits package. But only in moderation. Having the bulk of your retirement savings, for instance, wrapped up in the success of one company is very risky.
Municipal bonds, corporate bonds, and preferred stock are three of the biggest candidates for call risk. The company or government adds a callable clause that allows them to buy back the stock or bond before the maturity date. In return you usually see a higher yield to offset this risk.
For instance, a callable municipal bond is issued with a 6% yield. If interest rates fall, the call risk becomes high because the municipality is better off refinancing its debt. So it calls the 6% bonds and reissues new bonds at a lower interest rate. However, if interest rates are rising, the call risk is lower because there’s no point in refinancing at a higher rate.
Business risk or unsystematic risk is risk you find within specific companies. Generally you’ll find similar risks with companies in the same sector as well. Like you find with oil companies, for instance. Most oil companies deal with specific EPA standards and drilling practices. Diversification is an easy to limit your business risk.
Market risk or systematic risk is risk that affects all investments in the same market. For instance, by investing in stocks you take on the risks associated with that market. The same is true for the bond market and the real estate market. Each has its own unique risks. While diversifying with more stocks won’t limit your stock market risk, adding bonds would.
Political action and social upheaval are two big drivers of risk. But it doesn’t end there. There are different risks in any type of government. For instance, investing in China has different risks than if you focused on the U.S. Your investments are affected by changes in local laws, tax incentives, leadership, and major changes in government structure.
This is similar to political risk and business risk. Far too often new laws or regulations are put in place that affect a specific company or industry. Regulatory changes, like those in the banking industry, are in a constant state of flux. In the long run, these changes impact a company’s ability to earn money and profit. Not knowing the final outcome, adds extra risks to those stocks.
If you travel overseas you’ve experienced currency risk exchanging dollars for the local currency. The exchange rate on money changes constantly. It affects businesses and your investments. Emerging market funds and global companies can be affected the most.
Say you invest in India through an emerging market fund. The fund converts your dollars to buy the stock of local Indian companies in Rupees, India’s currency. Not only are you affected by the performance of the stocks, you also experience the changes in the exchange rate between the Dollar and Rupee. Any big change will have a big impact on your balance.
There are ways to limit these risks, diversification and healthy asset allocation is one way. Avoidance is another. While there are no safe investments, you can make investments safer by understanding the risks involved and avoiding those assets with a high certainty of risk.