Investing comes with the risk of losing your money is things don't work out like you hope. Another basic truth is that the greater risk you take, the greater return you might achieve.
Investors must understand the inescapable trade-off between investment performance and risk. Higher returns are associated with higher risks of price fluctuations. Stocks historically have provided the highest long-term returns of the three major asset classes while they have also been subject to the biggest losses over shorter periods. At the other extreme, short-term cash investments are among the safest of investments while providing the lowest long-term returns.
There are various types of risk.
Personal Risks
This risk deals with the personal level of investing. The investor is likely to have more control over this type of risk compared to others.
Timing risk is buying the right security at the wrong time or selling the right security at the wrong time. There is no surefire way to time the market.
Tenure risk is the risk of losing money while holding onto a security.
Company Risks
Financial risk is the danger that a corporation will not be able to repay its debts. This has a great affect on its bonds, which finance the company's assets. The more assets financed by debts (i.e., bonds and money market instruments), the greater the risk. Studying financial risk involves looking at a company's management, its leadership style, and its credit history.
Management risk is the risk that a company's management may run the company so poorly that it is unable to grow in value or pay dividends to its shareholders. This greatly affects the value of its stock and the attractiveness of all the securities it issues to investors.
Market Risks
Fluctuation in the market may be caused by the following risks:
Market risk is the chance that the entire market will decline, thus affecting the prices and values of securities. Market risk is influenced by outside factors such as embargoes and interest rate changes.
Liquidity risk is the risk that an investment will experience loss in value when converted to cash.
Interest rate risk is the risk that interest rates will rise resulting in an investment's loss of value.
Inflation risk is the danger that the dollars one invests will buy less in the future because prices of consumer goods rise. When the rate of inflation rises, investments have less purchasing power. Investments earning fixed rates of return are especially vulnerable.
Exchange rate risk is the chance that a nation's currency will lose value when exchanged for foreign currencies.
Reinvestment risk is the danger that reinvested money will earn returns lower than those earned before reinvestment. Dividend-reinvestment plans are a group subject to this risk. Bondholders are another.
National And International Risks
National and world events can profoundly affect investment markets.
Economic risk is the danger that the economy as a whole will perform poorly. Economic downturn stock prices, the job market, and the prices of consumer products.
Industry risk is the chance that a specific industry will perform poorly. Problems in an industry affect the individual businesses involved as well as the securities issued by those businesses.
Tax risk is the danger that rising taxes will make investing less attractive. Businesses that are taxed heavily have less money available for research, expansion, or dividend payments. Taxes are also levied on capital gains, dividends and interest earned by the investor.
Political risk is the danger that government legislation will have an adverse affect on investment. This can be high taxes, prohibitive licensing, or the appointment of individuals whose policies interfere with investment growth. Political risks include wars, changes in government leadership, and politically motivated embargoes.
Roger Sorensen
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