Risk Isn’t Just About an Investment Going Down in Value
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. In fact, other forms of risk can be just as bad or even worse than losing money on your investment. Investment risk comes in four flavors: market, credit, interest rate and inflation risk.
- Market risk – This is the risk most investors recognize. You buy a stock or other investment and there is a chance you could lose money if the value goes down. That’s the risk of the market and it’s easy to understand. Unfortunately, this is what most people latch on to when making their investment decisions and ignore the other types of risk.
- 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. So, just because an investment is labeled a bond, don’t assume there’s less risk involved.
- 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. 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. There is also opportunity cost with interest rates. Locking in a rate, whether it’s on a mortgage, auto loan, or certificate of deposit, means you could lose out on money if interest rates change. Getting a 6% mortgage when rates drop to 5% a year later could cost you tens of thousands of dollars. Buying a 5-year CD with a 2% rate while rates continue to rise in the coming years means money left on the table.
- 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 $250,000), but even these safest of the safe investments don’t mean an elimination of all risk. Inflation will wreak havoc with your real return. And while fixed income investments will often guarantee your principal and a predetermined return on your money (eliminating market risk), they can’t ensure that you’ll keep pace with inflation. It’s quite possible to see a net loss on what you thought was a risk-free investment.
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, the only risk you’ve eliminated is market risk. If your definition of risk is simply losing principal then you are correct.
But 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. In fact, after taxes you could very well be losing money. The same goes for those who primarily invest in bonds, and I see this more often than not with older investors. They move nearly all of their assets into bonds for the sense of security, but are shocked to find that interest rates change and may go very low or that bond prices can fluctuate actually resulting in a loss in their portfolio.
You can never eliminate all risk. Even locking cash in a safe isn’t without risk. Sure, you’ll always have that cash, but the value of the dollar changes over time. Inflation may eat away at its value. By not investing it you may lose out on money that could have been earned. And after taxes assessed when you spend that cash, you could actually see a significant loss on your cash even though it appeared to be safely locked away.
So, create a diversified portfolio and spread your risk around. You’ll never eliminate all risk, but you can diversify well enough that regardless of what the economy is doing you’ll still see results over the long run.
Author: Jeremy Vohwinkle
My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.
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Jeremy-Very informative and important info for the PF site reader. Get ready for some BIG TIME INFLATION. It is hitting hard at the pump and the grocery and with commodity prices soaring, there's not going to be an "inflation-free" zone!
For completeness, I would also include liquidity risk - the risk that there is a gap between the bidding price and the asking price. For most investors this only is apparent in their home cost (You think your home is worth x, but the buyers have a lower value in mind). The 10% penalty charged for tapping your 401K prior to 59 1/2 can also be thought of as a liquidity charge. Slightly more sophisticated investors might see this in option prices, private placement bonds, surrender charges on insurance products, and anything "exotic". In truth, we are all exposed to this risk within our mutual and bonds funds, we just rarely see it.
Excellently put. Risk is definitely not limited to just market fluctuations. There are so many sources of risk that to focus on just one seems incredibly unwise. The fact you could be losing purchasing power when the interest rate and inflation rate are both high (because of taxes on the interest) to me really emphasizes the problem with seeing certain investments as "completely safe."