Risk is the bane of all investors and it can come in many different forms.
Any investment that provides an opportunity for higher investment returns will inevitably involve a greater probability of loss; while those opportunities that offer lower rates of return should involve a smaller probability of loss.
To be sure, investment risk is not pure risk, since in the case of pure risk the only two possible outcomes are loss or no loss. Investment risk maybe thought of as speculative risk, since the possible outcomes can encompass either gain or loss in varying amounts.
The notion of speculative risk can have many facets. Market risk or systematic risk centers on the likelihood that an investor could experience losses due to factors that affect the overall performance of the financial markets.
Diversification in one’s investment portfolio cannot eliminate this risk, although it can mitigate it. The risk that a major natural disaster, such as a category 5 hurricane or a major recession, will cause a decline in the market as a whole are examples of market risk.
Liquidity risk generally is found with investments that are not that widely traded, such as stock that you may own in a local company. This type of risk comes about due to the lack of marketability of an investment that cannot be bought or sold quickly enough to prevent or minimize a loss.
Liquidity risk is typically reflected in unusually wide bid-ask spreads or large downside price movements. An investor in a bank CD could face a liquidity risk if he or she is forced to convert the CD into cash before its redemption date. In such cases, the investor would forfeit the interest that would have been paid when the CD’s duration period had been reached. The smaller the size of the security or its issuer, the larger the liquidity risks.
Other risks lurk in the wings for the unwary investor. For example, if my entire portfolio consists of the common stock of one company, I face a concentration risk, since I would have neglected to diversify my portfolio.
Investing in different types of assets, such as stocks, bonds, and money market accounts can provide diversification and lower concentration risk.
Investing in bonds can also be risky, since there may the possibility that the issuer of the bonds will redeem them before they are scheduled to mature. This is known as a call risk.
This redemption will usually take place when the prevailing interest rates drop significantly, thereby providing a company access to less expensive capital by issuing new bonds that carry lower coupon rates.
In the same vein, if interest rates rise, the value of my bond portfolio will go down, and this risk event is referred to an the interest rate risk.
Sadly, there is the specter of a political risk that can come about if decisions by the government will damage the value of your investments or will call for you to spend more of your investment dollars to confirm to the latest bill du jour.
This risk could be the longevity of your Social Security income, or the additional costs of a major government policy such as ObamaCare, or other government enactments might impact the investments in your portfolio. Then too, future tax law changes could take a bigger bite out of your retirement income.
Finally, there is the notion of a timing risk. Long range studies have shown that investing in the stock market over the long haul will provide an investor with the highest probability of successfully growing an investment portfolio. That notwithstanding, if your investment time frame is short, there is a timing risk that you may face.
I counsel my clients that if your time horizon is at least 5 years, you should allocate a goodly portion of your investments to the stock market, ideally with a passively managed fund.
If you will need to access monies in your portfolio sooner, you should possibly consider more conservative investments to protect yourself from a downturn in the market.
Greg Roberts is a certified financial planner with 35 years of financial and estate planning experience. Got a financial planning question for Greg? You may email him at firstname.lastname@example.org.
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