The potential return on any investment can generally be linked to the amount of risk the investor is willing to assume. Finding that balance between the return you desire and the risk you can accept has never been easy, and in the last nine months, it has been tougher than ever. What makes this even more problematic is that your financial goals and your risk tolerance usually change throughout your life. The investments that were right for you 10 years ago may not be as appropriate today, especially if you are knocking on retirement’s door.
It is always a good idea to review your investments periodically with risk tolerance in mind. If you listen to your financial advisor, you probably already review your account statements on a regular basis to monitor performance and change any investments whose performance is substandard. A good advisor will meet with you to do this at least annually. Take some extra time when doing this to screen your investments for increased levels of risk that you may now find uncomfortable.
Most people identify risk management with safety of principal. While a dollar locked in a bank safe deposit box or hidden in a mattress for 10 years will most likely still be worth a dollar when it is taken out, that dollar is not likely to have as much purchasing power in 10 years as it does today. In other words, locking your money away exposes it to inflation risk. What you gained in stability, you lost in buying power.
Like that dollar in the box, some investments are also exposed to inflation risk, such as bank deposits. No investment-not even cash in the mattress-is completely risk-free. There are many other types of risk as well, which apply to different securities. The following are some of the types of investment risks that you should keep in mind.
- Credit risk. The possibility that the issuer of an investment may not live up to its financial obligations and cause you to lose your invested capital or not receive expected interest payments. This is a current concern of bondholders in the auto industry.
- Market risk. An investment such as stocks, bonds and even real estate that may lose some or all of its value when traded in the financial markets.
- Reinvestment risk. The possibility that interest rates will fall as a fixed-income investment matures and cause you to be unable to reinvest matured assets at an attractive rate of return. We are currently experiencing this with bank certificates of deposits and government bonds.
- Interest rate risk. The risk that, if interest rates rise, the value of an investor’s bond holdings and certain stocks will decline.
- Liquidity risk. The risk that you will be unable to liquidate an asset such as real estate, collectibles or thinly traded stocks when you want and at the price you want.
While the variety of risks is substantial, don’t let risk management intimidate you. People participate in the financial markets because the rewards almost always outweigh the risks over time. By carefully assessing all the risks of an investment and periodically reviewing the holdings in your portfolio with your financial advisor, you should be able to find a level of risk that is appropriate for meeting your investment goals. iBi