At the time of this writing, inflation is pegged at over 8%. This is like losing 8% (annually), so without investments that might make up this loss, you are experiencing inflation risk – just one of many market and non-market risks associated with our financial wellness. When I hear someone say, “I don’t want to invest; it’s too risky,” I think they don’t understand it can be risky not to invest, as I’ve just illustrated.
Don’t get me wrong, investing carries risks, too. Unlike inflation risk, you have some say – some control – over how much investment risk you are comfortable with. Risk is inherent in stock markets, bond markets, and beyond. And where there is risk, there is often reward. That’s why investors invest – to build wealth, to send the kids to college, to gift to their church or favorite charity, to retire and live a comfortable life. So, what is investment risk, really?
Investment risk refers to the degree of uncertainty and potential financial loss of an investment or portfolio of various investments. When you invest your money in a stock, let’s say, the hope is that you will realize a return for having so invested. However, if you don’t receive the expected return, or even realize a loss, well, that was a potential outcome for that investment. Stock markets go up and down. If you bought a stock at an all-time high price and the stock market moved down, it is likely the price of your stock would move lower, too. On paper, it’s worth less than when you purchased it, even if nothing else changed – simply because the broader market declined in value. Thus, one of the cardinal rules of investing: buy low, sell high. That’s because the outcome will more likely be an investment gain than a loss if you purchase the stock at a (relatively) low price and hold it until you could sell it at a higher price and thereby realize a gain.
Types of Investment Risk
I just provided you an example of “market risk,” but there are different types of risk that can factor into the eventual outcome. This list is not all-inclusive, but below are some of the more commonly-discussed risks:
|Risk Type||Description||Impact on Investments|
|Inflation risk||The tendency for prices to increase over time||Future dollars (your investments) will not have as much buying power.|
|Longevity risk||The risk of outliving your savings||The length of retirement is undetermined, making it tough to know how much money you’ll need.|
|Market risk||The risk of loss due financial market performance||Stocks vary from day-to-day and year-to-year, which can have a negative effect on investments.|
|Interest rate risk||The risk to savings and loan rates if interest rates change||For money you want to grow (investments), interest rate increases are generally positive.|
|Credit risk (corporate bonds)||The risk of default by the issuer of the bond||Bondholders may not be paid the promised interest or the full principal.|
Other types of risk include political and currency risk, business risk, economic risk, liquidity risk, and concentration risk. You have little control over these risks, and yet, you do have the ability to manage risk. You can not remove all risk from investments, but you can manage the amount of risk – amount of volatility your portfolio experiences – using several key practices:
The bottom line is all investments carry some degree of risk. By better understanding the nature of risk, and taking steps to manage those risks, you put yourself in a better position to meet your financial goals.