Dealing with Investment Risks
Reader Question: What is “risk” and how can I reduce it?
Risk, in its most basic definition, is the chance of losing something of value, be that your health or your money.
Even the “safest” of investments have some risk. The risk may be very low, but it is still there. If you’ve got financial assets, they are in the financial system . . . and you cannot completely eliminate risk from the financial system. Take cash, for example. While it isn’t subject to market risk, it is subject to theft or loss of value due to inflation. Here are five types of risk and how to deal with each:
Interest Rate Risk is the possibility that bonds and other fixed-rate instruments will fall in value when interest rates go up. Treasury notes and bonds, real estate investment trusts (REITs) and preferred stocks are particularly susceptible to interest rate risk. Generally, the longer the time period that the interest rate is fixed (in other words, the maturity of the debt), the greater the decline in value. Three ways to reduce this risk include: 1. Sell all of your interest-sensitive investments and move into alternative investments that will either not be affected by rising rates or will be affected positively; 2. Stick with fixed-interest securities but shorten the maturities (e.g., sell your mutual fund that holds long-term bonds in favor of a short-term bond fund); and 3. “Hedge your bets” by selling some of your interest-sensitive investments and then using the proceeds to buy investments that could grow as rates continue to rise (for example, move from a portfolio with 100% bonds to a portfolio with 50% bonds and 50% stocks).
Credit Risk is the possibility that a debt issuer won’t be able to make interest and/or principal payments. If you purchased a ten-year bond and then the company doesn’t make the semi-annual interest payments or the final principal payment at the end of the term, then they will have defaulted on the debt. One of the common techniques for assessing this risk is to review the ratings assigned to debt by the Standard & Poors rating agency. Ratings range from “AAA” for the highest quality down to “D” for in default. Three ways to reduce this risk include: 1. Buy only investment grade, “BBB” or better rated debt; 2. Diversify the debt you buy to include AAA, AA, A, BBB, and even some BB and B (this strategy reduces risk and, generally, provides more potential interest than investing just in AAA); and 3. Opt for interest-earning vehicles without credit risk, like CDs from banks and fixed annuities from insurance companies; however, those options carry their own risks that need to be considered.
Inflationary Risk is the possibility that an asset, investment or your income will lose some of its purchasing power. One of the best ways to reduce this risk is to invest in assets with the potential to grow, like a portfolio of stocks or equity mutual funds.
Business Risk is the chance that a company may go bankrupt and, as a result, its stock or bond becomes worthless. Companies in the same industry can have similar business risks, but usually this risk is about an individual company. Diversification is one of the most common techniques used to address this risk. If you want to invest in the technology sector, you could buy stock in an individual technology company or, for reduced business risk, you could buy a mutual fund that holds one hundred or more such companies.
Market Risk is also referred to as “systematic risk” because it is the risk that affects the whole system. Generally, you can’t “diversify away” market risk because it is the risk that all the stocks fall in value. For example, if you had purchased at technology stock mutual fund back in 2000 (trying to reduce business risk), it didn’t matter much which technology mutual fund you owned, because most all of them fell. To reduce market risk, a step beyond diversification is required: the key to reducing market risk is to create a portfolio of investments that can move independently of each other (the fancy terminology is “non-correlated assets”). Mixing cash, CDs, domestic and foreign stocks, small and large company stocks, high quality and high yield bonds, real estate, commodities and precious metals in a portfolio could reduce your market risk.
All investors want to maximize their returns, but investment risks need to be kept under control. Risk management is one of the main reasons individual investors hire investment advisers and mutual fund managers to handle their money.