4. Understanding Risk
Risk is the possibility that an investment will lose value and is a fundamental part of investing. Stock markets plunge. Companies go bankrupt. And there are countless other less dramatic ways to lose money. There’s even risk in doing nothing. Because of inflation, money left in a savings account has to earn interest at least at the rate of inflation in order to stay even. To earn the highest returns, investors must assume a certain amount of risk. To minimize risk, investors must accept lower possible returns. It’s simple: generally, the higher the rate of return, the greater the risk; the lower the return, the lower the risk.
a. Types of risk
The five major financial risks are defined as follows:
1. Market risk
is the risk that the stock
market will go down and your principal, the amount you invested, will go down with it.
2. Financial risk is the risk that companies can go bankrupt. If you have invested in that specific company, you will likely not get all, or any, of your money back.
3. Purchasing power or inflation risk is the risk that your investments won’t earn more than the rate of inflation. This means that you don’t earn enough on your money to pay the higher prices of goods and services. You are essentially losing money because your money is worth less than it was when you invested it. Remember the $100 example above.
4. Interest rate risk is a more complicated concept, but an example will help. Say you buy a $1,000 bond (or a CD) that pays 5 percent per year for 10 years. If you hold the bond for 10 years at simple interest, you will get your 5 percent payment each year and the $10,000 back at the end of 10 years.
If you need the money within five years and the going interest rate at that time has gone up to 7 percent, nobody is going to want to pay you $10,000 for that five percent locked in product in year five. So, you must sell the bond at a price that will make the annual return to the new owner equal to 7 percent per year. You must sell your bond at a discount and take a loss in principal.
5. Fraud risk is the risk that someone is lying to you. Some investments are misrepresented. Therefore, it is important to investigate before you invest. A financial professional, like a Certified Financial Planner, can be a great resource to help you research and understand investments.