Investing always means taking a risk, but not every investment carries the same level—or even the same type—of risk.
For most people, risk means a possible loss of principal. But the risk of investing in insured products introduces the possibility that your rate of return won’t outpace the rate of inflation. In other words, your account balance might increase over time, but your buying power might decrease anyway.
Risk falls into two main categories: investment risk and portfolio risk.
Several elements contribute to investment risk, or the potential loss in value of individual investments:
- Company risk. Stock values drop due to a company’s internal problems or investors’ hanging attitudes about its products and services.
- Market risk. The overall value of stock or bond market drops, taking most investments down with it.
- Interest-rate risk. Bond and bond fund values drop due to changing interest rates.
- Credit risk. Bond issuers fail to make regular interest payments or repay principal upon maturity.
- Currency risk. Exchange rates fluctuate and affect the value of overseas investments.
Portfolio risk affects your overall account value and results from your particular combination of investments:
- Inflation risk. Low-risk investments with lower returns fail to outpace the rate of inflation.
- Diversification risk. Portfolio money is concentrated in too few investments that drop in value.
- Employer stock risk. Retirement savings are tied too closely with primary source of income—if one goes badly so does the other.
- Time-horizon risk. Frequent reallocation doesn’t allow for long-term growth.
Of course, you don’t face all of these risks with the same investment at the same time. Rather, risks tend to be cyclical, with one risk posing a serious threat in some periods but very little in others. For example, rising interest rates haven’t been a risk in the last several years. In contrast, company and market risk have had a strong negative impact on stock values.
Liquid Assets
When it comes to assessing risk, you should consider the investment’s liquidity, or how easy it is to buy or sell the investment. For example, you can always sell stock in large corporations at the current market price, though you may lose some principal if the price has dropped since your purchase. Real estate, on the other hand, is not liquid because you must wait to find a buyer and negotiate the price. |
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