All of us are exposed to risk each day of our lives, whether it is weather, driving, accidents, or disease, etc.
Likewise, investments are not exempt from risk. In financial terms, risk is the chance that an outcome on investment gains will differ from an expected outcome or return. This could result in a loss of some or all of the original investment.
A comment I often make when talking about investments (and risk) is that there is no perfect investment. Every investment has its’ own element and degree of risk. To expand upon this, every investment has pluses and minuses, hence one of the reasons that there are thousands of investment choices. Just for the sake of trivia, according to a website called Statista1, in 2019, there were 7,945 mutual funds in the United States. Add to this, individual stocks, bonds, exchange traded funds, various types of annuities, structured notes, CDs, retirement plans, options, commodities, cryptocurrencies, etc.
But I digress. To me if there were a perfect investment, it would have a high rate of return, virtually no investment risk, be nontaxable, and liquid. Well, I’m still searching for that perfect investment.
Although there are many different types of investment risk, I would like to touch upon a few.
This is usually associated with the viability and performance of an individual company or enterprise. This would include its stock, bonds or other securities associated with this entity.
This is the risk that your investment will decline because of economic developments or other events that affect the entire market. For instance, a mutual fund holding the stocks of 50 different corporations would have very little business risk but would be impacted by market risk.
Credit or Default Risk
This is about whether or not a borrower will be able to pay the contractual interest or principal on its debt obligations. Corporate bonds would be subject to this risk.
Foreign Exchange Risk
When investing in foreign countries, the currency exchange rate can have an impact on the value of an investment. For instance, if you invest in a Canadian stock, even if the stock price rises, you could lose money if you the Canadian dollar depreciates relative to the U.S. dollar.
This pertains to the ability to convert an investment into cash. Generally, investors would demand a premium in exchange for tying up their investment for a period of time.
Interest Rate Risk
This is the risk that the value of an investment can change based upon a change in the absolute level of interest rates, the spread between two rates, or in any other interest rate relationship. Bonds are impacted by this risk. For instance, as interest rates rise, bond prices in the secondary market fall and vice versa.
Inflation or Purchasing Power Risk
The risk that cash flows from an investment won’t be worth as much in the future because of changes in purchasing power, due to inflation. In the case of a taxable investment it is where the “real return” (the return after taxes and inflation) doesn’t keep up with inflation.
For instance, you might be satisfied with an investment that has an interest rate of 2.5% But if you were in the 24% tax bracket, your return would be 1.9% after taxes. If inflation were 2.0%, you would actually have a negative real rate of return. This would not be good if your financial plan was predicted on a real rate of return of 2.5%.
Just as in other areas of your life, you want to manage investment risks to achieve an acceptable level. In this regard, important considerations are: your age, how long before dollars will be needed, what rate of return is needed to accomplish your goal, having sufficient dollars for emergencies, asset allocation, diversification, your risk comfort level and how hands on you want to be (which would be influenced by your investment knowledge).
What I would call your risk tolerance is a very important consideration. It is crucial that, emotionally, you’re able to stick with your investment for the long term. Although not scientific, there are various risk tolerance quizzes/questionnaires that would help determine your risk tolerance. Click here and take a quiz to see what level of risk might appropriate for you. Keep in mind that, as discussed above, there are other important factors that need to be considered when choosing investments. Give us a call and we can discuss your retirement and/or investment plan.