There are many types of investment risk. The more you understand the risks, the more secure you will feel. Each has its own characteristics and degree of importance.
An investor must understand each type of risk and use that knowledge to create a portfolio of investments that balance the level of risk assumed, with the desired investment return. How you invest and how much you understand is a big part of managing your wealth in a way that makes you feel secure.
Risk and reward go hand in hand. Usually the greater the risk an investor is willing to undertake, the greater the potential reward… or loss.
It would then seem that the smaller the risk, the less the yield, but the higher degree of safety for the investment. However, there are many types of risk that apply to almost every investment and unless they are understood, the investment might not be appropriate for the needs of the person making the investment.
The following are many types of risks and a TIPto mitigate or avoid that risk: This is serious business and each needs to be considered when you are deciding on your investments.
If it appears that I am trying to scare you, well, maybe I am. You should be very careful with your decisions and always consider what would happen if what you do turns out wrong.
- Market Risk – This can be defined as the possibility of downward changes in the overall stock or other market. This does not relate directly to the individual investment, but to a more macro environment. An example is where the entire stock market drops as a result of the Federal Reserve Chairman suggesting that the Federal Reserve might raise interest rates. TIP: One way to deal with market risk is to diversify your investments over various asset categories and also within those categories such as stocks, bonds, cash and real estate and other categories. Holding assets from different categories reduces the possibility that all investments will be down at the same time.
- Inflation Risk – For many individuals, safety of principal is the primary goal when deciding where to place investment funds. Such investors frequently put much of their money in bank savings accounts, CD’s or U.S. Treasury Bills. While such investments can provide protection from market risk, they do not provide much protection from inflation risk. An investor may hold the same number of dollars but, over time, those dollars buy less and less. Most methods of shielding your portfolio from inflation risk involve you in a higher level of risk. Placing a portion of your assets in the stock market, or buying long term bonds presents a greater risk than short term fixed income investments. TIP: One way to reduce this risk and still keep a conservative portfolio is to ladder your bonds and CDs.
- Credit Risk – Also known as default risk. This reflects the chance that the issuer of a bond or other debt-type instrument will not be able to carry out its contractual obligations. TIP: Keeping maturities short, diversifying investments among various companies and investing in institutions and issues of the highest credit rating are methods used to control this type of risk.
- Liquidity Risk – This recognizes the possibility that an investor will not be able to sell, or liquidate an asset, without losing a portion of the principal because there is an imbalance between the number of buyers and sellers, or because an asset is not traded very often. TIP: Choosing investments traded on an active market and limiting investments to funds not needed for current expenses are approaches used to lessen this risk.
- Interest Rate Risk – The risk that an increase in the general level of interest rates will cause the market value of existing investments to fall. Generally, this risk applies to bonds and other debt-type instruments, which move opposite to interest rates. As interest rates rise, bond prices tend to fall and vice versa. In the case of interest rate risk, time is a factor. The longer the time before maturity, the greater the potential for fluctuation in the value of the bond. TIP: One approach to reducing this risk is to stagger, or ladder the maturities in the portfolio so that a portion of the portfolio matures periodically, rather than all at the same time. Buying bonds you intend to hold, and can hold, until maturity, at which time it is redeemable at full value, eliminates this risk.
- Tax Risk – The possibility that a change in tax laws, at either the federal, state, or local level, could cause an investment to no longer meet an individual’s requirements. This has occurred many times. In particular the 1986 tax law effectively ended tax shelters AFTER Congress specifically enacted certain tax laws to encourage the private sector to invest in rehabilitating run down urban neighborhoods that the Federal Government wanted done, but did not want to appropriate funds directly from the Federal Budget. Other laws subjected Keogh plans to estate taxes when it was specifically excluded initially, have substantially increased capital gains taxes up to just under 50% for a number of years, taxed Social Security payments, “taxed” municipal bond interest to the extent it triggers a tax on Social Security earnings, and the Alternative Minimum Tax voids many payments of State and Local income and real estate taxes. TIP: Making an investment because it’s a good investment, rather than a good the tax saving devise, is an excellent way to reduce this risk.
- Economic Risk – This is the danger that a downturn in the economy or other significant economic event will depress the value of your investments by reducing earnings capabilities. TIP: Here diversification over broad categories and possibly foreign investments that do not cycle in tandem with each other can cushion against this.
- Specific Risk – Relates directly to the individual investment itself. This covers such elements such as new technology making a certain firm’s products obsolete, greater competition reducing earnings capabilities, management changes, recalls, product liability claims, and bad accounting data. TIP: Diversification is the way to reduce this risk on your total portfolio. This is a reason why many people invest in mutual funds and index funds – specific risk is spread over a large number of companies.
- Forecast Risk – Many times a stock rises because of anticipated increases in earnings or other good news. When the forecast fails to materialize the stock drops, and often to a lower level than where it started out. Stocks can also drop when the forecast is met because the anticipation is that the estimate will be exceeded. TIP: Diversification is a solution.
- Fashion Risk – Things go in and out of style. Investments are no different. When choosing investments do not be swayed by what happens to be in style at that moment. Choose companies that have established solid reputations and don’t look for the current flavor of the month. Asset group investing is a popular “fashion.” If you put a disproportionate portion of your assets in a particular sector, you will be overexposed to risk if that sector goes out of fashion. TIP: As with some many other types of risk, diversification is the way to mitigate the effects of this risk.
- Timing Risk – You could be completely right, but act too early. Acting too late is not a timing risk – it is a mistake. TIP: The way to guard against this is to develop a plan that will be implemented over a period of time and stick to it. The vagaries of the market will be evened out. Market timing is not an effective strategy.
- Time Risk – Not the same as timing risk. Here your investment horizon changes, or you needs change and you have to liquidate an investment. In that case you will have to take what the market offers, which could be considerably less than had you waited until maturity or the length of time you originally planned to hold that investment. TIP: The way to protect against this is to have a good thought out strategy that takes into account the possibility of changes.
- Investment Manager Risk – This is the risk that the person managing your investments, or advising you, leaves, changes, or reverses their goals or style, and does so in a manner not consistent with what you thought you were getting. TIP: To protect yourself against this is to have more than one advisor with each being a member of your team. Another way is to spread your investments over different mutual fund families. Also, looking at the long term strategy of the manager rather than the current track record and personality can help you. You should also remember that the market has no memory and a great track record is no prediction that it will continue. On the contrary, that great track record may have had the investment run up too much, leaving little potential for growth and a large potential for a drop.
- Health risk – There is a risk that your health will change requiring a drastic alteration of your investments and cash flow needs. TIP: Your investments should be set up to provide a secure cash flow base to cover many eventualities including the need for a complete refocusing.
- Loss of market confidence risk – This is the general fear the market is disintegrating and there is a rush out of the markets or money rushing away from certain types of stocks [such as financial institutions] or money rushing into complete safety of Treasury Bills providing even a negative return such as we have seen in October 2008 –March 2009. Other instances are the loss of confidence in the prices of certain sectors such as we have seen in the drop of many the NASDAQ stocks in 2000. TIP: Partial protection is to have diversification with no heavy concentration in one area, sector or type of investment. A pre 2008 “conservative” portfolio of primarily financial institution bonds was a prescription for disaster the end of 2008.
- War or terrorism risk – A completely unexpected irrational event could cause markets to be closed, liquidity curtailed, extreme uncertainty of future conditions, and panic selling. Whether the markets correct themselves or not, short term activity can be greatly affected. TIP: Protection against this is to have ready cash and available funds to meet short term needs. Some would even suggest some gold on hand.
- Warren Buffett risk – This is where Warren Buffett (or Berkshire Hathaway) or another person with similar “clout” makes a tender offer to acquire a company and there are no competing offers because no one wants to antagonize him. Believe it or not, this has happened! This reduces the upside potential from competing offers or bids. TIP: A diversified portfolio will protect you from this having a meaningful effect on you.
- Politically correct risk – Massive stock positions could be sold precipitously because of perceived unpopular activities by a company. An example could be a company that is doing research in areas that certain groups perceive as being for immoral purposes, or that they are not “green” enough, or employ child labor. TIP: The recurring theme of a diversified portfolio protecting you should be heeded.
- Devaluation risk – Currency devaluations are occurring regularly throughout the world – either politically or economically. A devaluation of the dollar can instantly reduce the buying power of savings and investments. Devaluations are relative to other currencies and the interlocking economic activity must be understood. Many advisors suggest investing globally but many major United States based companies do half of their business off shore eliminating the need for separate foreign investments, and the risk or insulation from a strengthened or devalued U.S. dollar is included in those investments. TIP: Your protection should be with a well-diversified portfolio that possibly should include some foreign stocks and bonds, but also the knowledge of what percentages of activity the companies in your portfolio (either with individual stocks or bonds or through mutual or index funds) have in other countries.
- Madoff risk – This is the risk that you are cheated either from a Ponzi scheme or your broker or advisor. Many people don’t realize it but many of the giant brokerage firms and mutual fund managers have been fined billions for “cheating” their customers by steering them into the wrong type of or inappropriate investments or into their own mutual funds that had subpar performance.TIP: It is very hard to protect yourself from someone you know and trust who is intent on cheating you. A way to partially protect yourself is to understand what you are investing in and how you can make and lose on the investment, and what interest the advisor has in it, if any. Also, you need proper due diligence going in and adequate oversight while you are in the investment.
- Category risk – the company is in a category or industry that drops out of favor reducing valuations. An example of an out of favor category is magazine or newspaper publishing; and in favor categories such as social network and e-commerce businesses. TIP: broad based diversification protects from this.
- Fiscal Cliff risk – a brand new one. This is where Congress acts totally irresponsibly, irrationally and with no consideration of the electorate they serve and the commonweal of the country. Compromise is important in legislation but when political considerations overshadow the real problems and no one steps up to address (or even define) the real issues, we have a problem. When spiteful small minded mean spirited people govern (from both sides of the aisle) we have a problem, and this is represents a great risk we need to be aware of. TIP:Taking a long view and investing in a well-diversified manner based on your goals can protect you from this risk.
- Resource drag risk – This risk occurs where there are insufficient resources available to satisfy demand. Shortages can be caused by many reasons including local wars, labor and capital shifting to the then current higher profitable areas, new products using up present supplies, or a simple bad judgment in anticipating demand when scheduling production. Whatever the reason, shortages can cause user company values to drop TIP: This, like most of the risks, need diversified portfolios that are constructed to achieve long term objectives.
All these risks need to be considered. Sound investment review, understanding, questioning, diversification and matching with your goals and strategies will serve to reduce these risks, but can never eliminate them completely. Basically, there is no way to invest that is entirely risk free; but by doing the right work and using the right team of advisors, you can reduce many of these risks.