We take risks everyday. Did that cook at your local burger joint REALLY wash his hands with soap after his latest trip to the bathroom? Can your Dad-bod pull off those skinny jeans or will you just be totally embarrassing yourself? These are risks I am sure almost all of us can relate to, but what are investment risks all about? Let’s take a look!
No matter the investment type or vehicle, when we take our hard earned money and invest in something, we do so because we anticipate and hope for a positive return. We expect to get our principal (original investment) back plus a little extra as well! The reality that an investment might return less than what is expected is known as “investment risk”.
One of the universal truths with investing is that you can’t have risk without reward and you can’t have reward without risk. The more risks you are willing to take, the greater the potential reward. Conversely, less risk normally means less reward. Unfortunately there is no risk-free, high-reward investment. If there was, you wouldn’t be reading this blog post because you would be chilling in your skinny jeans somewhere, flush with cash and without a care in the world!
Let’s dig into the different types of investment risks.
Simply put, this can be defined as the potential for downward changes in the market price of an investment that will result in a loss of principal for the investor. For most, the market risk is most closely associated with the ups and downs of the stock market.
The stock market isn’t the only player however when it comes to market risks. Bonds and other debt investments will usually move up and down in response to changes in interest rates. When interest rates go up, bond prices generally go down. If interest rates drop, bond prices usually go up. Tangible assets like gold, real estate and collectibles can also face market risks.
Here are a few strategies you should consider that might help reduce market risks. Remember these suggestions are not a guarantee of any future performance.
- Only invest cash that you do not currently need. In other words don’t invest money that you are currently using for living expenses. This can help avoid the need to sell an asset when the market may be down.
- Think more long-term. When you are in it for the long haul, you can often times ride out the inventible ups and downs that are a part of every market and make for a smoother, less stressful journey.
- Don’t put all of your eggs in one basket. Diversify your investments across different types because generally speaking, not all types of investments will be down at the same time. When you diversify, even if one of your strategies isn’t working, the others might be, helping your ship to remain afloat.
For a lot of investors, protecting their principal is the primary goal when deciding where to put their money. These types of investors frequently put a large portion of their cash in savings accounts, CDs or T-Bills. Although these investments have much lower risks, they do not provide very good protection against inflation. Although your account value may be the same or slightly higher than it was when you opened the savings account or CD, those dollars can now buy less thanks to inflation.
Lets look at a hypothetical investor who places $10,000 in a 10-year CD that earns a fixed rate of 2% a year. The chart below shows the effect of a 3% annual inflation rate as it relates to the purchasing power of the investors $10,000.
- Credit Risk: The chance that the issuer of a bond or other type of debt investment type will default and not be able to carry out it’s obligations.
- Liquidity Risk: The possibility that an investor will not be able to sell or liquidate an asset without losing part of the principal.
- Interest Rate Risk: This is defined as when an increase in the general interest rates causes the market value of an investment to fall.
- Tax Risk: A change in the tax laws either at the state or federal level has an impact on the tax characteristics of an investment.