Up until this point we’ve mentioned the varying degrees of risk in different investments a few times. I’d like to look more closely at risk and find out what it means how we can deal with it. Risk is the possibility of loss to your investment. If there is no guarantee that you will recieve your maximum possible return, then there is risk of some kind. All investments involve risk.
MRisk of loss of principal. This is the most basic kind of risk. The principal is the original amount of money that you invested. If you buy a stock or mutual fund or invest in real estate, there is no guarantee that you will get all of your principal back. You can greatly reduce or eliminate the risk to your principal by keeping your money in a bank savings account, purchasing a fixed term deposit (agreeing to deposit your money for a specified amount of time), or buying investment grade bonds. But even when you guarantee your principal, there are still other kinds of risk.
M Inflation risk. This is the risk that your money will hold less value in the future than it does now. Keeping your money in a bank savings account, and to a lesser extent a fixed term deposit, exposes you to inflation risk because your returns will probably be lower than the rate of inflation. This is why banks are terrible places to leave large amounts of money for more than a short time.
M Opportunity risk. This occurs when you lock up your money in an illiquid investment, like a fixed term deposit with very modest returns, and miss an opportunity to invest in something with a chance of much higher returns. When I first began learning to invest, I was in a hurry to get started and put around $5000 into a fixed term deposit. I didn’t know much about investing, so I plopped my savings into a guaranteed investment. About 1 day later, there was a drastic drop in the stock markets, which would have been a golden opportunity for me to buy stocks while prices were low. But I couldn’t buy stocks, because I had committed that $5000 to a 1 year fixed term deposit with no option of early redemption. I could have made some real gains on the stock market, but I was stuck with a modest 5 percent interest rate. I had avoided risk to my principal, but I was bitten by opportunity risk. You can avoid opportunity risk by keep your money in liquid investments like stocks and mutual funds with no minimum time commitments.
M Marketability risk. Similar to opportunity risk, this is risk that there will be no buyer available when you wish to sell your investment. This is important especially with real estate. Selling property can take a long time. You need to hire a realtor, advertise, have open houses, etc. If you need that money immediately, you will likely be out of luck. Your money is tied up for the time being. Real estate is not a good investment to make if you may need to liquidate it anytime soon, or at short notice. M Concentration risk. One of the most major kinds of risk, this occurs when you have too much of your money concentrated in one area, for example all in one particular stock or all in one industry. Have you heard of Enron? Well, anybody who had their investments concentrated in Enron ended up getting the shaft. When the dot com bubble burst several years back, a lot of people who had their money concentrated in new internet businesses lost everything. The lesson to learn here is to diversify your investments. Diversification, as we’ve mentioned before, means holding a variety of different investments across a variety of sectors so that if one of your investments flops, you are losing only a small portion of your money rather than a large portion of it or, God forbid, all of it. It’s of central importance to build a diversified portfolio to reduce your concentration risk.
M Interest rate risk. This is the possibility that the relative value of your investment will decrease due to changes in interest rates. This is mainly relevant for fixed income investments like bonds. If you buy a bond with a fixed 5% interest rate, but then market interest rates increase, you may be stuck with that bond at a 5% interest rate even though bonds with higher interest rates are now being issued. The dollar value of your investment upon maturity doesn`t change, but the relative value has changed, since there are now other people out there earning more interest than you. This will decrease demand for your bond, so if you decide to sell it it will fetch you a lower price than the newer bonds with higher interest rates. Interest rates have a profound effect on various aspects of investment, but this is the most basic kind of interest rate risk to understand for now.
M Currency exchange risk. Currency exchange rates are constantly fluctuating and can change the value of your investments. If the base currency of your investment is different than the currency you are purchasing with, then the value of your investment will fluctuate depending on the currency exchange rates. For example, if you buy a China growth mutual fund whose base currency is the Chinese Yuan, and you buy it in US dollars, then any increase in the Yuan will work in your favor when you sell the investment, and any decrease in the Yuan will work against you when you sell the investment. This risk can not be eliminated and it is best to have a balance of hard currencies. Hard currencies are basically trusted currencies of stable countries with consistent fiscal policies.
Those are some of the major types of risk you need to be aware of. Once you understand these kinds of risks, you can determine your own risk profile and decide how much risk you are prepared to take on.