Identifying potential threats to your investment goals allows you to develop strategies to mitigate risks. For investors, risk refers to the chance of losing part or all of your principal, or not achieving the returns necessary to meet your financial objectives.
Return, on the other hand, represents your profit or loss from an investment. It encompasses both the income earned from dividends or interest and any changes in the investment’s value.
Anatomy of investment risks
Risk can manifest in various forms, and there are multiple strategies to safeguard your investment portfolio against these risks. Understanding and addressing these risks helps in maintaining and potentially enhancing your portfolio’s performance.
Systematic Risks
Systematic risks, which are inherent to the entire market or a broad sector, can be mitigated through asset allocation. For instance, during a period of stock market gains, losses often follow. By maintaining a balanced portfolio that includes bonds and cash in addition to stocks, you can cushion the impact when stock prices decline.
Non-Systematic Risks
Non-systematic risks, specific to individual securities or sectors, can be managed through diversification. For example, while a highly rated bond might initially seem like a safe choice, it could face a downgrade, leading to a decrease in its market value. A well-diversified bond portfolio reduces the likelihood of all holdings being downgraded simultaneously, thereby minimizing the impact of any single security’s poor performance.
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While there are no guarantees that history will repeat itself, there are some investment risks you should fully expect to encounter:
Market Risk
Market risk involves the inherent fluctuations in securities markets driven by various factors—economic conditions, political events, and even market sentiment. When an entire market or asset class declines, most individual investments within that category are likely to experience losses as well.
Interest-Rate Risk
Interest-rate risk affects bond prices because they typically move inversely to changes in interest rates. If interest rates rise, the market value of existing bonds tends to fall. This could result in a loss of principal if you need to sell your bonds, similar to how selling stocks during a downturn could lead to losses.
Currency Risk
Currency risk comes into play if you hold international investments. As exchange rates between the US dollar and foreign currencies fluctuate, the value of your investment returns can be impacted by these changes.
Inflation Risk
Inflation risk represents the threat that rising costs will erode your purchasing power over time. If your investment returns do not outpace the rate of inflation, you effectively lose value in terms of real purchasing power.
Prepare for the unexpected
No matter how carefully you select the investments for your portfolio, there are always things that take you and other investors by surprise.
Company risk
Company risk refers to the potential for a specific company to experience difficulties that impact its financial health and stock or bond prices. This can occur due to factors like a competitor offering a superior product, poor management decisions, or a scandal damaging the company’s reputation. When such issues arise, investors may sell off their shares or bonds, leading to a decline in the asset’s price.
Credit Risk
Credit risk is the chance that a bond issuer may fail to make the scheduled interest payments or repay the principal amount when the bond matures. This risk is also relevant for fixed annuities.
Political Risk
Political risk pertains to the potential for political events or instability to impact investments, particularly in emerging markets. Changes in government, policy shifts, or instability can disrupt markets and limit opportunities for foreign investors.
The risk of safety
If you’re overly concerned about the risk of losing money and choose to invest predominantly in highly secure options like insured CDs and US Treasury bills, you’re focusing on preserving your principal. Essentially, you aim to get back what you invested, plus interest. However, relying solely on this strategy for the long term carries its own significant risks. Typically, insured investments offer lower returns compared to uninsured alternatives. Additionally, inflation can erode your real returns and diminish your purchasing power over time.
Risk tolerance
Understanding the relationship between risk and return allows you to make informed decisions about taking calculated risks to achieve your financial goals. For instance, you might choose to invest in a higher-risk asset if you anticipate its long-term returns will surpass those of a risk-free investment. This potential excess return is known as a risk premium. The 13-week US Treasury bill, or 90-day bill, is often used as a benchmark for risk-free investments due to its minimal risk. A T-bill is considered risk-free for two main reasons:
It’s issued by the federal government, making it virtually free of default risk. However, you could still lose money if you sell it before its maturity date.
Its short-term nature means it’s less susceptible to inflation risk.
To calculate past risk premiums, you can use different formulas depending on the investment. For example, with large company stocks, you would divide the total return (which includes earnings and changes in value) by the total return of T-bills. If this ratio is positive, it indicates that the risk taken has been rewarded. From year-end 1925 through 2016, large-company stocks had a positive risk premium approximately 70% of the time (64 out of 91 years), while in 27 years, the risk premium was negative.
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