A personal finance blog dedicated discussing such topics as budgeting, asset allocation, 401K, IRA, cash flow, insurance, financial planning, portfolio management, and other areas in personal finance.


Wednesday, August 24, 2005

Let's Talk About Risk

In the investment world "risk" is defined as fluctuation. Of course, we are really only concerned with DOWNWARD fluctuation. Anyway, there are many different kinds of risks involved in investing. I'm going to take a couple of posts to talk about them.

I got the idea for this series of posts from Ric Edelman's book The New Rules of Money, which is a pretty good book (I can't say that about the rest of his books). Ric is a financial advisor and author. He also has a website.

So, what are the major types of risk? I'll list them first and then I'll go back and explain each one:

  • Default risk - The risk that an investment will become worthless. Does this remind you of Enron or Worldcom? Those people who had all their wealth tied up in those two companies lost it all. However, this risk can be minimized through proper diversification. Had you owned Enron or Worldcom in a portfolio of stocks, the impact of their default wouldn't have been nearly as severe.

  • Credit risk - This is the risk that an investment's financial stability might decline. Although this risk involves stocks, it is particularly important to bond investors. If you own a bond in a company who's credit rating gets cut by the bond rating services, the value of your bond is going to decrease. This is another type of risk that can be diversified away.

  • Tax risk - The risk of loss due to taxes (income and capital gains taxes). Loss to taxes can be either postponed through tax-deferred accounts like 401(k)s, IRAs, and annuities. Loss to taxes can be eliminated with the use of a Roth IRA or Roth 401(k).

  • Inflation risk - A very real risk faced by everyone (some have more exposure than others). This is the risk that an investment's purchasing power will be eroded by rising prices. This is a very real risk to someone invested in interest-bearing accounts. Stocks have been shown to handle inflation risk pretty well as long as the inflation is low to moderate.

  • Interest rate risk - The risk that interest rates will rise. If you buy a bond today for $1,000 that pays you 4% per year and then interest rates rise to 4.5%, your bond is worth less than the $1,000 you paid for it. Why? Becuase why would anyone want to pay you $1,000 to earn $40 per year when they could buy a bond for $1,000 that pays $45 per year?

  • Currency risk - The risk that foreign currency exchange rates will rise. If you are a US citizen and have an investment in China and China's yuan increases in value against the doller, your investment will decrease in value. (This looks like an excellent follow-up topic)

  • Political risk - This risk is related to currency risk. Political instability can be a substantial risk when investing in other countries - especially emerging markets. Diversification can reduce this risk.

  • Market risk - This risk has to do with the price fluctuations of the market as a whole. There's not a lot that can be done about market risk except for ignoring it.

  • Event risk - The risk that something unexpected and beyond management's control will cause the invesment's value to fall. September 11, 2001 is probably an the example most people think of.

  • Prepayment risk - The risk that the investment's principal will be returned sooner than expected. Investors in callable bonds face this risk when interest rates decline.

  • Extension risk - The opposite of prepayment risk. In other words, you might not get your principal back as soon as you expected.

  • Opportunity risk - The risk that by investing your money in one place you are missing out on the returns "you could be getting" elsewhere. Diversification can rid you of most of this risk.
If you are like me, you probably didn't think there were that many different kinds of risks. These risks are all very real and should definitely be considered when making your investment plans. However, please realize that risk is natural and in most cases if you want a decent return, you are going to have to except some risk.

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