Financial advisors and investors alike throw around the word investment risk an awful lot. Most of the time, each party assumes it means the risk of an investment losing its principle value but there are at least seven different areas of investment risk that you and I need to know.
Seven Types of Investment Risk
- Interest Rate Risk
- Business Risk
- Default Risk
- Diversification Risk
- Inflation Risk
- Market Risk
- Empty Bucket Risk
Interest Rate Risk
This type of risk usually involves bonds and bond investing, where the value of a bond decreases when interest rates rise. Think of it this way, if you bought a corporate bond with an interest rate of 3 percent and interest rates rose to 4 percent, would anyone want to buy your bond from you at full price? No, of course not. They would only want to purchase it at a discount … a discount that allowed them to actually make 4 percent.
Will the company you’re investing in go out of business? What are the chances the business will lose value if a competing product has a detrimental effect on the company’s core business?
Will the company (or municipality, county, or even state!) default on their bond obligations? No one thought it was possible, but governments have defaulted on their bonds and that’s a risk that you and your financial advisor need to consider. It’s a good reason to get with your advisor and consider fixed income and bond ETFs.
Also known as “non-systemic risk,” you can eliminate diversification risk by investing in large index funds via exchange traded funds (ETFs). Diversification will also help reduce or even eliminate completely your business risk.
Inflation risk is the risk that your investment returns will not outpace inflation. It’s usually associated with living too long! If you invest ONLY in the safest investments, you can safely assume that you’ll safely go broke. Seeking protection from short-term declines in your portfolio by investing in low yield investments means you either need to have a huge nest egg or you’ll need to withdraw tiny amounts from it.
Market risk simply refers to the volatility of the stock market. Dips in the market always make headlines but they’re rarely significant over the long term. You can reduce market risk by not placing all your money in the stock market. Given enough time, market risk is never permanent … so long as you don’t well in a down market.
Empty Bucket Risk
Empty bucket risk is the risk that you’ll run out of money before you run out of life (read How Long Will You Live?). Most savvy financial advisors tell their clients to withdraw no more than four percent of the total value of their retirement savings each year. The Four Percent Theory however, is a moving target and should be adjusted depending on the economy and your portfolio’s performance. If the market takes a tumble and your accounts are suffering, four percent next year will be substantially less than four percent this year.
Few people can assess risk
Few people can accurately assess their own risk tolerance and even fewer can accurately determine an investment’s risk. Why? Two reasons:
- Emotions: Emotions constantly get in our way and cloud our judgement but many times we’re aware of our emotions and their effects on our decision making process.
- Bias: Bias creeps in when we least expect it and we rarely even recognize it when it does.
These two reasons alone are reason enough to consult with a qualified and screened investment advisor from WiserAdvisor. A savvy financial advisor can determine (with your input) your personal risk tolerance and match it with an investment vehicle who’s risk meets your requirements.
There’s only one way to make money
Sell an investment for more than it cost you. But there are thousands of ways (it seems) to lose money. Make the right choices regarding an investment’s risk and you’ll lessen your chances of coming out on the losing end.