Broker Check

Understand Risk

Few terms in finance are as important, or used as frequently, as “risk.” Nevertheless, few terms are as ambiguously defined. Before exploring risk in more formal terms, a few observations are worthwhile. Generally, when advisors or the media talk about investment risk, their focus is on the historical price volatility of the asset under discussion. There are different types of risk that make up the overall risk of an investment.

Even though you might never have thought about the subject, you’re probably already familiar with many kinds of risk from life experiences. For example, it makes sense that a scandal or lawsuit that involves a particular company will likely cause a drop in the price of that company’s stock, at least temporarily. If one car company hits a home run with a new model, it might be bad news for competing automakers. In contrast, an overall economic slowdown and stock market decline might hurt most companies and their stock prices, not just in one industry.

There are many different types of risk to be aware of when you make an investment decision. These include, but are not limited to:

  • Market risk – this refers to the possibility that an investment will lose value because of a general decline in financial markets, due to one or more economic, political, or other factors.
  • Inflation risk – sometimes known as purchasing power risk, this refers to the possibility that prices will rise in the economy as a whole, and so your ability to purchase goods and services would decline.
  • Click here for an illustration of Inflation Risk.
  • Interest rate risk – this relates to increases and decreases in prevailing interest rates and the resulting price fluctuation of an investment, particularly bonds. There is an inverse relationship between interest rates and bond prices. As rates rise, the prices of bonds fall; as rates fall, the prices of bonds rise.
  • Reinvestment rate risk – this refers to the possibility that you will have to reinvest funds at a lower rate of return than the original investment.
  • Default risk (credit risk) – this refers to the risk that a bond issuer will not be able to pay its bondholders interest or repay principal.
  • Liquidity risk – this refers to how easily your investments can be converted to cash. Occasionally (and more precisely), the foregoing definition is modified to mean how easily your investments can be converted to cash without significant loss of principal.
  • Political risk – this refers to the possibility that new legislation or changes in foreign governments will adversely affect companies you invest in or financial markets overseas.
  • Currency risk (for those making international investments) – this refers to the possibility that the fluctuating rates of exchange between US and foreign currencies will negatively affect the value of your foreign investment, as measured in US dollars.

The Relationship between Risk and Reward

Why all this emphasis on understanding risks, and your individual tolerance of it? In general, the more risk you’re willing to undertake (whatever types and however defined), the higher your potential returns, as well as potential losses. This proposition is probably familiar and makes sense to most of us. It is simply a fact of life – no sensible person would make a higher-risk, rather than a lower-risk, investment without the prospect of receiving a higher return. That is the tradeoff.

As an investor, your objective is to maximize returns without taking on an inappropriate level or type of risk which is why understanding your own tolerance for risk is important in establishing your investment objectives.

Investment Strategies

There are several strategies that investors utilize to reduce risk. The most common is diversification strategies. Simplified: don’t put all your eggs in one basket. With diversification you can potentially help offset the risk of any one investment by spreading your money among several asset classes that do not have prices that move together. This strategy hopes to take advantage of the fact that forces in the markets do not normally influence all types of classes of investment assets at the same time or in the same way; however, diversification cannot guarantee a profit or ensure against a potential loss.

An example of another strategy is Protect and Advance. This strategy is used extensively at AIS Financial, specifically with clients nearing retirement and those in the retirement phase of their lives. Unlike diversification, Protect and Advance takes a more active approach to help mitigate risk in an investor’s portfolio by analyzing market trends and positioning the investments within the portfolio accordingly. As with all investment strategies, Protect and Advance cannot guarantee a profit or ensure against a potential loss.