What is Investment Risk?
How often have you heard someone say, "I've had it with risk. I'm ready to sit tight for a good long time in a safe investment like a CD. Let other people invest in the markets. They can take as much risk as they want, but not me. I don't want any risk!"
Whether you invest in something as exotic as a small-cap emerging markets fund, or as plain vanilla as a CD, your money is subject to some form of risk. You can't avoid investment risk, but you can manage it more effectively.
In order to manage risk in your portfolio, you first need to understand the different forms of risk so you can then decide which type of risk is more acceptable to take.
Market Risk – The risk of investments declining in value due to fluctuations in the overall price level of stocks. These fluctuations are typically caused by economic developments or other events that affect the entire market.
Interest Rate Risk – Risk of losing money in bonds because of a change in interest rates. Bond prices and interest rates are inversely related, so when interest rates fall, the value of bonds rise, and vice-versa.
Currency Risk – With regards to foreign investments, it's the risk of losing money because of a movement in the exchange rate. For example, if the US dollar becomes less valuable relative to the Canadian dollar, your US stocks will be worth less in Canadian dollars.
Credit Risk – Risk that a government entity or company that issued a bond will run into financial difficulties and won't be able to pay the interest/coupon or repay the principal at maturity.
Bonds rated BBB or higher are considered "investment grade".
Concentration (non-diversification) Risk – The risk of loss because your money is concentrated in 1 single investment or type of investment. We typically see this for our clients who receive stock options from their employers. When you diversify your investments, you spread that risk over different types of investments, industries, geographic locations, etc. This is one major benefit of mutual funds in that if there is a drop-in value of one stock or bond in that fund, it has a smaller impact on your total portfolio.
Liquidity Risk – The risk of not being able to sell your investment at a fair price and get out of an investment when you want to. Even CDs involve liquidity risk, selling before a CD matures can lead to either penalties from a bank, or if purchased in a secondary market can involve selling the CD at a lower price than when purchased.
Inflation Risk – The main risk from inflation is the danger that it will reduce your purchasing power and the returns from your investments. Inflation erodes the purchasing power of money over time – the same amount of money will buy fewer goods and services. This is the hidden risk of owning CDs, you will have less real purchasing power when your CD matures. The need to stay ahead of inflation is a powerful reason why investors turn to growth investments like stocks, even though this means accepting frequent price fluctuations.
Written by Daniel M. Song, CFA®.
Dan is a Portfolio Analyst with Westfield Financial Planning