No investment in the world is without risk. Yes, retirees that includes your local bank CD! When you mention the word risk, most people think of the stock market or the potential to lose your money. Unfortunately, risk cannot be avoided when trying to build long-term wealth for life’s goals.
Now the trick is measuring and evaluating the risks for each investment. This is where investors often misunderstand, or apply personal biases to their choice of investments. Either taking too much, or even too little risk. There are four broad categories of risk that can determine whether an investment is appropriate for you or not.
Market risk is probably the one everybody things of when they think of risk. It is often called systematic risk. This is the risk that cannot be diversified away. There is no way to control or reduce market risk. It consists of the values of the investments just fluctuating due to the economy or the overall world conditions. A good example would be buying high a high quality bond. At some point, sentiment changes and investors feel that very little money can be made on these bonds, and therefore the price declines. The investment is still good quality but lost money.
Interest Rate Risk
This is the possibility that an investment will decline due to a change in interest rates. Bonds, REITs and most fixed income investments are subject to interest rate risk. If you buy a 5% municipal bond and interest rates increase, then the value of your bond will probably be worth less because new bonds issued will have a higher interest rate.
This is the risk that your money will hold less value in the future than it does now. Like high blood pressure, this is the silent killer in the investment world. All investors are subject to inflation risk. If you leave your money long-term in savings accounts and CDs, exposes you to inflation risk because the returns for these investments are lower than the rate of inflation. That’s why banks are bad places to park significant savings for long-term goals.
I probably only have to say one word for you to understand this risk….Greece. When I first came into the investment business, foreign investments didn’t seem to affect domestic investments nearly as much. Today is a new world. We are globally connected almost as one world economy. Countries that are unstable politically can dramatically influence investment returns. Europe’s debt issues could send it spiraling into recession and possibly trickling over to the United States.
There are many different types of risks associated with investing. Currency and security risk are two more examples. These four will help you assess most investments. Spend some time thinking about risk, you may find that you need to re-evaluate yours. If you want to have your investments reviewed for their risk, write me at firstname.lastname@example.org or call me at (859) 225-2596.