When you think of investment risk, what comes to mind? Is it the recent volatility of the stock markets – up one minute, down the next? How about speculative investment derivatives, such as options or futures contracts, used to bring down Barings Bank in 1995, or the more recent occurrence in September 2011 when the Swiss Bank UBS lost over $2 billion (yes, that’s billion with a “B”!). And who hasn’t heard of Bernie Madoff and his Ponzi scheme, considered to be the largest financial fraud in US history. Makes one want to hide their money in their mattress and forget about it. Or does it?
Yes, these are definite investment risks. But there are others most people don’t know about that should be taken into consideration when choosing your investments. Unfortunately, there is no such thing as a “risk-free” investment, and your individual situation will determine how much risk you can, or should, accept.
Here are some additional risks you should consider and how you may be able to minimize them:
Market Risk
The most obvious, and most talked about these days, is market risk, otherwise known as systematic risk. This is the risk that the value of an investment portfolio will decrease due to a change in factors that determine the entire market. Interest rate changes, recessions, wars, and, more recently, the European debt crisis, affect the entire market and cannot be avoided by diversification. In other words, owning the stocks of several different companies will not eliminate this risk as all stocks will likely move in the same direction in the event of bad news… down!
Company/Industry Risk
Also know as un-systematic risk, company risk can be diversified away as it is the risk to an individual company or industry, not to the market as a whole. For example, by owning the stocks of several different companies in different industries, un-systematic risk will be reduced if factors negatively affect only a few of the companies you own.
Country/Currency Risk
Country risk is the risk of investing in a country which could be adversely affected by its political and economic environment, in addition to exchange rate, sovereign and transfer (the risk of capital being frozen by government action) risks. With emerging markets being popular investment choices these days, keep these risks in mind when deciding where and how to invest. Currency risk is the potential loss arising from the change in one currency relative to another. If you are a Canadian and have stocks in the US, the total return is determined by both the return on the stocks, as well as the change in the exchange rate of the US to the Canadian dollar.
Reinvestment Risk
Normally used in the context of bonds, reinvestment risk is the risk of having to reinvest future proceeds at a lower return. This will usually occur during times of falling interest rates, where interest payments can only be reinvested at rates lower than the original yield to maturity (the expected rate of return if a bond is held to maturity).
Interest Rate Risk
Affecting bonds more than stocks, this is the risk that an investment’s value will change due to a change in interest rates while holding the bond. This is an inverse relationship where, as interest rates rise, bond prices fall, and vice versa. For example, a 10% bond purchased last month will be worth less if interest rates rise because investors could now get a higher return elsewhere in the market.
Liquidity Risk
An investment that cannot be bought or sold quickly in the market without incurring excessive costs faces liquidity risk. Liquidity risk can usually be found in emerging or low-volume markets, where the participants may have trouble finding each other.
Inflation Risk
My grandfather used to say “I remember when these only cost a dollar…” Well, that loss of purchasing power is inflation risk – the very real risk that the value of your money today will be worth less in the future. In other words, if you store your money in a mattress thinking you are avoiding risk, think again. On average, your money is eroding about 2-3% per year. Likewise, any investment that does not yield an after-tax return greater than the rate of inflation each year, such as many savings accounts, money-market funds, bank GICs, and some bonds. And while the stock market may yield negative returns in a given year, over the long-term, returns have historically been higher than the rate of inflation.
As you can see, there is such a thing as a “risk-free” investment. The way to minimize these risks is to be sure you have a well diversified portfolio of different assets classes (stocks, bonds, or their corresponding mutual funds), sectors (for stocks, financials, materials, energy, utilities, industrials are some examples of different sectors that make up the Toronto Stock Exchange), and companies.
The easiest way to achieve this is with a balanced mutual fund, but, as with any investment, don’t put your money into anything you don’t understand, and be sure to read the details of the plan before committing. Be sure you understand the risks and potential returns involved.
Joanne believes that financial independence is the cornerstone to living an empowered and enriched life… and money doesn’t have to be intimidating!
Download your FREE report “Achieve Your Financial Goals in 10 Easy Steps” here: http://www.financialskillscentre.org/free-download/
And be sure to join her Facebook page at http://www.facebook.com/FinancialSkillsforWomen
No comments:
Post a Comment