There Is More To Risk Than Meets The Eye

Investors generally think of risk as simply the chance of losing part or all of their investment. While this is certainly one type of risk when it comes to investing, it is definitely not the only type risk. Investment risk comes in four flavors: market, credit, interest rate and inflation risk.

• Market risk – This is the risk most investors recognize. Stocks typically outperform other investments over the long haul. Time is the key; allowing investments to ride out the highs and the lows that are common in the stock market. But remember, past performance of an investment does not guarantee future results. Yes, stocks historically have had a higher rate of return than bonds or money markets over time, but this return is not guaranteed and it is possible to lose money.
• Credit risk - Fixed income securities, such as bonds, are generally considered to be more stable than stocks. However, over the past 25 years, bonds have been as volatile as stocks with less reward. There’s also the bond’s rating; its credit-worthiness can affect its performance. The lower a bond’s rating or quality, the higher the potential return, but the higher the risk. Bonds can also default and bond holders can lose their principal unless the bond is insured.
• Interest rate risk – This is the risk that the relative value of a security, especially a bond, will worsen due to an interest rate increase. Bond prices act inversely to interest rates. If interest rates rise, the underlying bond price will fall and vice versa. This is not much of a concern if the bond is held to maturity, but interest rate risk can cause a loss by selling a relatively safe investment before maturity.
• Inflation risk – Uncle Sam guarantees the bonds it issues. Certificates of Deposit (CDs) issued by banks are also federally insured (the basic insured amount of a depositor is $100,000), but neither of these investments mean an elimination of all risk. Inflation, when it matches or exceeds your investment return, will play havoc with your retirement nest egg. And while fixed income investments will often guarantee your principal and a predetermined return on your money, they can’t ensure that you’ll keep pace with inflation. These investments, while they guarantee your principal may end up costing you in the long run.

I see many people who think that they are eliminating risk by investing almost solely in money markets, CDs or other fixed instruments. While on the surface it does seem that by doing this you eliminate risk, and if your definition of risk is simply losing principal then you are correct.

It is also important to realize that if you are earning a guaranteed 5% interest rate while inflation is running close to 4% you really aren’t earning much of a return. The same goes for people who primarily invest in bonds, and I see this more often than not with retirees. They move nearly all of their assets into bonds for the sense of security, then like the past year as interest rates have been rising they come to me upset because their actual portfolio of bond holdings has decreased significantly in value. If they continue to hold their bonds until maturity, no harm no foul, but panic selling can create a loss with even the safest investments.

It pays to create a diversified portfolio that addresses your risk concerns across every category since each investment style has different associated risks. If you understand that there is more to risk than simply losing money in the stock market you will become a better investor.

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1. Don’t Forget About Your Maturing CDs – It Could Cost You
2. Investment Returns Are Not Always What They Seem
3. Brokerage Money Market Funds – A Great Cash Option
4. Who Doesn’t Save For Retirement? Most Americans, It Seems.
5. Investing for the Real Payoff