We all take risks in the hope of gaining something. It may be buying a home, changing careers or going back to school. Investing, like many other things in life, involves risk in order to achieve return. While it’s normal to be concerned about the security of your money, a narrow perception of risk can be limiting. In fact, by fully understanding investment risk and how it relates to potential returns, investors can help strengthen their portfolios and improve their chances for greater wealth.
Defining Risk: Many investors view risk as the possibility of losing money, but it’s really much more complex. Risk can affect your investment in a number of ways. Below are some of the most common forms of risk, along with their potential impact on any of your investments.
Market/Downside Risk: Factors, such as recession, inflation or changing interest rates, can all influence market movements, and the value of your investments. Values may fluctuate in response to the activities and financial prospects of an individual company. Financial markets are dynamic, so it’s normal for investment values to change daily and the degree to which these values fluctuate determines the volatility.
Interest Rate Risk: Bond funds are perceived to be safe as they have experienced less historic price volatility. However, individual bonds are issued with a fixed rate of interest, so their values fluctuate in response to changes in current interest rates. When interest rates increase, the value of an existing bond goes down, because it is paying a lower rate than what investors could earn elsewhere. Conversely when rates decrease, bonds increase in value because they are earning a higher rate. Similarly at today’s historically low GIC rates locking up your money for 5 years at under 2% interest does not make much sense with annual inflation in the 3% range.
Credit Risk: If the company that issues a bond experiences financial difficulty or fails, bondholders may not be paid the promised interest or the full amount of their principal. This is referred to as credit risk. To help investors understand the extent of credit risk associated with different bonds, there are third-party organizations to evaluate and rate bonds. The higher the rating, the higher its quality, but in exchange for greater safety though, higher quality bonds have less return potential. Likewise, lower quality bonds generally pay a higher interest rate to compensate investors for greater credit risk.
International Risk: There are a variety of risks involved with international investing. Foreign markets may be less mature and less regulated than US financial markets. The issuer of an international security may be subject to greater political or economic uncertainty. Foreign securities can gain or lose value when converted from one currency to another. However, international investing gives investors the opportunity to participate in a broader range of companies and economies. In many cases, these companies may offer greater potential than US-only investments. Also, a fund that is invested in several different countries can reduce risk through greater diversification.
Inflation Risk: Some investors choose investments with fixed or guaranteed interest rates, such as bonds or certificates of deposit, because they desire security of principal. But inflation poses a risk to these investors, because there is a chance that the fixed rate may not keep pace with the rising cost of goods and services over time.
(See part 2 next week)
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