Understanding Risk
This past year has been a tough year for investors. With inflation higher and the Federal Reserve raising interest rates, conservative investors lost money for the first time in many years. While we expect that equity markets can be volatile, conservative investors putting money into bonds never expected to see a down year. But with interest rates going up, bond investors did suffer unexpected losses.
All investors – be they conservative, moderate, or aggressive – need to understand that the level of returns they expect to generate is directly related to the amount of risk they are willing to assume – the higher the return, the higher the amount of risk one needs to take. It probably doesn’t dawn on most people that you assume some risk regardless of where you put your money. For instance, if you focus solely on keeping your money safe from the possibility of loss, you risk not accumulating enough money to meet your goal. In this case, avoiding “market risk” increases your exposure to other types of risk, such as “inflation risk.”
Understanding the different types of risks and how they can individually and collectively impact your long-term investment performance is crucial to constructing a well conceived portfolio that can maximize your returns while
reducing your overall risk.
DIFFERENT TYPES OF INVESTMENT RISK:
1) MARKET RISK: The risk that most people associate with investing is market risk, the possibility of losing money due to the price fluctuations of the markets. Because it is difficult to know which way prices will move, investors can lose money if the market moves against them. However, losses are only realized if the investment is sold.
2) INFLATION RISK: Many risk-averse investors prefer the safety of savings accounts, CDs, and bonds. The risk they face is that the growth of their secured savings doesn’t keep pace with the inflation rate, which will, in effect, reduce the value of their money in the future.
3) INTEREST RATE RISK: The prices of interest-bearing securities, such as government and corporate bonds, fluctuate in response to the movement of interest rates. As interest rates rise, the prices of these securities will decline. So, as safe as government and high-quality corporate bonds are, it is still possible to lose money. The investor receives the bond’s total face value if the
bonds are held to maturity.
4) LIQUIDITY RISK: Investors concerned with having immediate access to their money need to be aware of liquidity risk. The safest investments, such as CDs, have some liquidity risk because if it is redeemed too early, the investor could lose a part of his principal. And, even though stocks, bonds, mutual funds, and exchange-traded funds (ETFs) can be liquidated at any time, investors may be reluctant to do so if they are in a loss position.
Having a long-term investment horizon will allow your investments to work through the inevitable volatility of any market cycle. As uncomfortable as it may be, the only actual losses are when you sell an asset. Holding on through the tough times has always proven to be a winning strategy.