Understanding Risk: Part II
Provided By Stephen J. Barrett, CFP®, AWMA®, AIF®
Vice President, Wealth Management
January 31, 2018
Other types of risk
Here are a few of the many different types of risk:
- Market risk: This refers to the possibility that an investment will lose value because of a general decline in financial markets, due to one or more economic, political, or other factors.
- Inflation risk: Sometimes known as purchasing power risk, this refers to the possibility that prices will rise in the economy as a whole, so your ability to purchase goods and services would decline. For instance, your investment might yield a 6% return, but if the inflation rate rises to double digits, the invested dollars that you got back would buy less than the same dollars today. Inflation risk is often overlooked by fixed income investors who shun the volatility of the stock market completely.
- Interest rate risk: This relates to increases or decreases in prevailing interest rates and the resulting price fluctuation of an investment, particularly bonds. There is an inverse relationship between bond prices and interest rates. As interest rates rise, the price of bonds falls; as interest rates fall, bond prices tend to rise. If you need to sell your bond before it matures and your principal is returned, you run the risk of loss of principal if interest rates are higher than when you purchased the bond.
- Reinvestment rate risk: This refers to the possibility that funds might have to be reinvested at a lower rate of return than that offered by the original investment. For example, a five-year, 3.75% bond might mature at a time when an equivalent new bond pays just 3%. Such differences can in turn affect the yield of a bond fund.
- Default risk (credit risk): This refers to the risk that a bond issuer will not be able to pay its bondholders interest or repay principal.
- Liquidity risk: This refers to how easily your investments can be converted to cash. Occasionally (and more precisely), the foregoing definition is modified to mean how easily your investments can be converted to cash without significant loss of principal.
- Political risk: This refers to the possibility that new legislation or changes in foreign governments will adversely affect companies you invest in or financial markets overseas.
- Currency risk (for those making international investments): This refers to the possibility that the fluctuating rates of exchange between U.S. and foreign currencies will negatively affect the value of your foreign investment, as measured in U.S. dollars.
The relationship between risk and reward
In general, the more risk you're willing to take on (whatever type and however defined), the higher your potential returns, as well as potential losses. This proposition is probably familiar and makes sense to most of us. It is simply a fact of life--no sensible person would make a higher-risk, rather than lower-risk, investment without the prospect of receiving a higher return. That is the tradeoff. Your goal is to maximize returns without taking on an inappropriate level or type of risk.
The discussion of “Understanding Risk” will conclude next week with understanding your own tolerance for risk, reducing risk through diversification, and evaluating risk.
Broadridge Investor Communication Solutions, Inc. does not provide investment, tax, or legal advice. The information presented here is not specific to any individual's personal circumstances.
The content of this article was edited and updated by Stephen J. Barrett, CFP®, AWMA®, AIF® of Strategic Financial Group, LLC.
Advisory Services offered through Strategic Financial Group, LLC (SFG) (dba SFGI, LLC in Illinois), a Registered Investment Advisor.
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