Most investors realize that the money they invest in the stock market comes with a certain amount of risk. However, there are other potential risks to a portfolio that don’t get as much attention, which investors should also be aware of.
The potential return from any investment can generally be linked to the amount of risk the investor is willing to assume. Finding that balance between the return you desire and the risk you can handle has never been easy. What makes this problem even trickier is that your financial goals — and thus your risk tolerance — inevitably change throughout your life. Therefore, the investment that was right for your goals of yesterday may not be so appropriate today.
It is a good idea to review your investments periodically with risk tolerance in mind, whether you do this on your own or with an adviser.
Most people identify risk management with safety of principal. This is true to an extent — a dollar locked in a safety deposit box for 10 years will most likely be worth a dollar when it is taken out.
Of course, that dollar is not likely to have as much purchasing power in 10 years as it does today. In other words, locking your money away exposes it to inflation risk. What you gained in stability, you lost in buying power.
Like that dollar in the box, some investments are also exposed to inflation risk. There are many other types of risk as well, which apply to different securities. The following are some of the types of investment risk you should keep in mind.
- Market risk — the possibility that an investment may lose its value when traded in the financial markets.
- Credit risk — the possibility that the issuer of an investment (a corporate bond, for example) may not live up to its financial obligations and cause you to lose your invested capital or not receive expected interest payments.
- Interest rate risk — the risk that, if interest rates rise, the price (value) of an investor’s bond holdings and certain stocks will decline.
- Reinvestment risk — the possibility that interest rates will fall as a fixed-income investment matures and cause you to be unable to reinvest matured assets at an attractive rate of return.
- Liquidity risk — the risk that you will be unable to liquidate an asset (such as real estate, collectibles or thinly traded stocks) when you want and at the price you want.
Brett N. Karras is president of the Karras Company, an independent registered investment adviser with approximately $800 million in assets under management.
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