Many investors view the stock market as risky, because they may lose money. In our eyes, it is worthwhile to have some awareness of the various types of investment risk. In our video, we share several sources of investment risk that you may not have fully considered. Below, we talk in more detail about those risks.
First, let’s simply list a few of the investment risks, and we will dive deeper into a few of them to illustrate the point. Here is a list of well-known risks:
• Market Risk (also known as Systematic Risk)
• Interest Rate Risk
• Business Risk
• Inflationary Risk
• Liquidity Risk
• Reinvestment Risk
• Social/Political/Legislative Risk
• Currency/Exchange Rate Risk
• Call Risk and Credit Risk (specific to bonds)
Those are a lot of risks, but hopefully it is not overwhelming. For example, in our last video we talked about diversification and asset allocation which, combined, can be used to mitigate (but not eliminate) several of the risks above, including Market Risk, Business Risk, Exchange Rate Risk, and even Social/Political/Legislative Risk.
Today, I would like to point out Inflationary Risk, in particular. An item costing $100 in 1985 would cost about $220 in 2015 due to inflation. This is serious damage to your purchasing power and can make retirement a lot less enjoyable than you might want it to be. In general, it is a good idea to have many of your investments at least keeping up with inflation. Historically, stocks have done this while cash or near-cash investments have not.
Another current risk to be aware of is Interest Rate Risk. Interest rates have been at historically low levels, and it is hard to imagine them doing anything other than going up. As interest rates rise, the unfortunate result is that bonds go down in price. We did not elaborate on the mechanism for this in the video, but we will do so here. If a person owns a bond that is paying $50 per year on a $1,000 investment, that is a 5% return. Now imagine that over a few years, the market interest rate has moved up to 10%, and the owner wishes to sell the bond. Who will buy that bond at the full price of $1,000? No one. The new buyer wants to earn the current market rate. Since the bond will continue to pay only $50, the way to achieve a current market rate is discount the price so that 10% is earned on the reduced price.
The key takeaway from this is that there are many risks to consider. Sometimes the risks are the ones that scream from the media headlines on a daily basis. Just as often, risk can be silent but can significantly affect the value of your investments, nonetheless.
Patrick Stoa
For questions, comments, and conversation, call us at 920-617-6830
The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Any opinions are those of Mike Macco and Patrick Stoa and not necessarily those of Raymond James.