What is Investment Risk?

Because investment involves trade-offs, there is always a risk that comes with investing our money. If you hold cash in your mattress, you will never earn interest and risk losing purchasing power to inflation or, even worse, your home being burglarized or burning down in a fire. On the other hand, if you lend someone money there is a risk that the borrower will not repay you when the time comes. Likewise, when you purchase an investment there is a risk that the bank, government, or company may not be able to pay you back or even that it may go out of business, leaving you high and dry.

In general, the greater the risk the investor assumes, the greater the potential reward and the greater the anticipated rate of return we expect. The key is to determine the suitability of various types of investments and how they weigh your logical decisions verses your emotions if and when your investments experience volatility.  Risk is inherent any time we invest our money with an expectation of growing our investment, and risk is characteristic in all business activities over time. Because of this, good risk management is essential when building your investment portfolio. 

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Thinking about financial risk often prompts us to become short-sighted when thinking about where and how to invest our hard-earned savings. When the market is having record days and all-time highs, such as during a bull market, we often become overly confident and discount the real possibilities of a future downturn. On the flip side of that, we often become overly cautious in the wake of a significant market downturn or when there is uncertainty in the economy. Either condition can have disastrous consequences on your investment portfolio over time.  In fact, many investors do not properly gauge their personal feelings of risk. As a result, they lose a large portion of their investment in a sudden downturn, pull their money at the bottom of the market and avoid reinvesting as the markets recovers from losses, causing irreversible damage to their overall financial well being.

When you are making investment decisions, always consider the different types of risk that you may encounter, this will help you in creating an effective strategy where you can balance your logical head and your emotional heart in order to survive the financial ups and downs that come with investing.  Knowing some of the different types of risk is the first step in helping you maneuver murky waters of investment risk.

When experts talk about risk, you will hear them referring to systematic risk, a type of risk that affects all investments, and unsystematic risk, a type of risk that affects some businesses and not others.  Some of the most common types of risk include:

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Market Risk

Almost all types of stocks and bonds involve some degree of market risk. This is the risk that investors may lose some of their principal invested due to volatility in the market overall. This is a type of systematic risk investors’ face. An investor cannot avoid market risk through diversification. Should the entire market fall, all investments would likely decline as well.

Inflation Risk

Also known as purchasing power risk, inflation risk is the effect of rising prices due to inflation, resulting in less purchasing power as time goes on. In savings accounts or other cash alternatives, such as certificates of deposits or government treasuries, you may see that your investment may not keep up with the rate of inflation. The purchasing power of your invested dollar will be less than it was before you invested.

Reinvestment Risk

When interest rates decline, it is difficult for investors to reinvest the proceeds of their investments when they come due in products like certificates of deposits (CDs), bonds, and treasuries or when preferred stock is called by the company, and still maintain the same level of return at the same level of risk. Think of it this way, if you purchased a five year CD in 2015 at an interest rate of 5% and you wish to reinvest your principal and the interest you earned in another CD in 2020, you will be looking at a rate closer to 1% for the same level of risk you took in 2015.

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Credit Risk

Also known as default risk, credit risk involves losing all or part of your principal due to a company or government failing. Credit risk is related to debt securities and varies by product and the credit rating of your investment.

These are by no means all the types of risk you may face, but these are some of the most common risks you may experience.  It is important to know the different types of risk when building your portfolio and how you feel about each to know how you will navigate them before they happen. It is important to gauge your personal risk tolerance. This will help you when it comes to creating a diversified and disciplined investment strategy.

Tell me your stories and your thoughts by leaving a comment below. Let’s have a better money conversation.

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