Types of risk
A review of the basic kinds of risk, including inflation, liquidity and credit.
Risk is a part of investing. The thing that’s important to remember is this: regardless of what kinds of investments you choose, there’s always some kind of risk involved, and you need to be comfortable with your investment decisions.
When it comes to investing, the question isn’t whether to take risks. Unfortunately, you can’t avoid them. That’s why you need to decide what kind of risk you are comfortable taking, and how you can manage it.
Maybe you prefer putting your money in a savings account or a CD (certificate of deposit) because it feels safe. Believe it or not, both of these strategies carry some degree of risk. There’s a chance your money may not be able to keep up with inflation. That means your dollar may be worth less in future years.
The money you invest is called your “principal.” Unfortunately, you don’t always make money on what you’ve invested. In fact, you can even lose some or all of your principal. The chance that you may lose money is principal risk. This risk is commonly found with investments in stocks but can affect other types of investments, as well. (Please note that the return of principal for any bond holdings in our funds is not guaranteed. Shares of bond funds and funds with bond holdings are subject to the same interest rate, inflation and credit risks associated with the underlying bonds held by each fund.)
There is a risk that the price of a stock or bond will fluctuate because of changes in interest rates. If interest rates go up, bond prices typically go down. If rates go down, bond prices typically go up. Since stocks and bonds can react differently to the same events, diversifying your investments by investing in both can help reduce the volatility, or the swings, in your overall portfolio’s value.
Both stocks and bonds are vulnerable to changes in the economy and to general changes in the markets they trade in. Although stocks and bonds issued by companies are tied to profits and losses of those companies, there are factors and cycles outside of the companies’ control that may cause a rise or fall in prices.
Think credit cards. When you borrow money you have to make payments plus interest to pay off your debt. The same holds true for companies that issue bonds (or IOUs) to the public. There’s a chance companies that issue bonds won’t be able to make interest payments or return all of your principal. That’s credit risk.
Let’s say you needed to buy a car or home, and you had to have the money tomorrow. If you couldn’t sell or redeem an investment quickly at a fair price to get the cash, it’s an indication that your investment has low liquidity. A lack of liquidity can affect the price of stocks and bonds.
This risk encompasses all the other types of risk. The size and frequency of fluctuations in an investment’s price determines its volatility.
If you have questions about risk and your investments, talk to your financial adviser.
Note: Be sure to discuss these issues with your financial adviser before making any changes to your financial plan.