Successful investments can be extremely profitable. But the stocks with the greatest potential tend to be the riskiest. And underlying risks aren’t always obvious. In fact, there are several different types of risks for investors to consider, based on your portfolio’s asset allocation.
Here are six ways to review and calculate the risk of an investment before you decide to put down your money:
1. Market risk. This is the risk that the price will decline due to market factors as well as changing economic, political or individual circumstances. Typically, investments in securities such as stocks, bonds and mutual funds will fluctuate over time, based on these factors. If you don’t have a significant time horizon — perhaps, ten years or more — you might allocate a smaller part of your portfolio to volatile securities.
2. Credit risk. Also known as financial risk or default risk, credit risk is generally associated with bond investments. Bonds issued by the federal government are considered to have minimal credit risk. On the other hand, high-grade corporate bonds generally carry a higher risk. Finally, “junk” or “high-yield” bonds are known to carry the greatest credit risk. Of course, many bonds pay a premium or higher rate of interest to offset higher credit risk.
3. Currency risk. Although investing on a global scale may provide growth opportunities, doing so adds additional risk relating to political, economic and market instability. For example, currency risk exists due to fluctuations in the value of the currency underlying securities in foreign investments.
4. Inflation risk. This refers to the risk that purchasing power will be reduced as inflation erodes the value of assets. In other words, it will cost you more tomorrow to buy the same items you bought today. To combat the long-term effects of inflation, you might take a more aggressive approach to stock and stock-based mutual fund investments that could outpace inflation over a period of time. Caveat: There are no absolute guarantees concerning performance of these investments.
5. Interest rate risk. This is the risk that you will be unable to reinvest your earnings and principal at maturity at the same rate if interest rates are falling. For example, if you have invested in CDs that pay 4% annually, you may not be able to reinvest in a CD paying as high as 4% when it matures.
6. Tax risk. No matter what happens in the financial markets, you can’t avoid death or taxes. Remember it’s how much you keep from your investments — not how much you earn — that truly matters. You can take steps to minimize the tax erosion from your investments with assistance from a financial professional.
There’s no getting around risk if you’re going to invest. The question is, how much risk are you willing to assume? The answer is something you should discuss with a trusted advisor based on your goals, your resources, when you’ll need the money and what will allow you to sleep at night.
Please contact Judith Barnhard via our online contact form for more information.
Councilor, Buchanan & Mitchell (CBM) is a professional services firm delivering tax, accounting and business advisory expertise throughout the Mid-Atlantic region from offices in Bethesda, MD and Washington, DC.