Many individuals avoid investing – or make inappropriate investment decisions – because they fail to understand risk. The more you understand risk and its impact on investments, the better investor you can become.
One of the most common types of risk is market risk. Market risk refers to the possibility that the price of a security will fall below its purchase price due to overall market declines. All investments – stocks, bonds, mutual funds, etc. – have market risk. Understanding the market risk of a security can help you protect assets and maximize investment potential.
Inflation risk refers to the impact inflation has on your purchasing power. If you earn 3% on your money (after taxes) but inflation is 4%, your money isn’t growing as fast as inflation (i.e., the cost of living.) Hence, you’re losing purchasing power. If this trend continues over several years, your standard of living could be jeopardized.
Liquidity risk is the possibility that the number of sellers of a security will exceed the number of buyers. Generally, when there are more sellers than buyers, prices fall. When buyers outnumber sellers, prices rise to reflect the growing demand.
Bonds and other fixed-income securities are subject to interest-rate risk. Interest-rate risk refers to the fact that a bond may decline in price when interest rates rise because its coupon rate may be less than rates available on new bonds. The market pushes down the price of existing bonds, so their current yields are similar to yields on new bonds, making them more attractive to prospective buyers.
Another risk faced by most bond investors is credit risk, also called default risk. Credit risk refers to the fact that the underlying issuer of a bond will not be able to meet its obligation to pay interest or return principal. U.S. government securities are not subject to this risk because they’re backed by the full faith and credit of the U.S. government.
Rating services, such as Standard & Poor’s and Moody’s Investors Service, rate bonds and periodically review the creditworthiness of the issuing company. These ratings are intended to help investors identify companies that might default before repaying principal on their outstanding debt. As circumstances dictate, these ratings services upgrade or downgrade as needed.
Some bonds can be “called” or repaid by the issuer ahead of schedule. Hence, such bonds have prepayment risk. When bonds are called, the holder of the security loses future interest payments from that security. Unless the holder can reinvest the proceeds at a rate equal to that of the called bond, the portfolio’s income is reduced. Bonds are often called when there are few attractive investment alternatives available.
In recent years investors have stepped up their investment outside the U.S. While international investing offers attractive opportunities, it involves special risks best described by your Financial Advisor. He or she can also answer questions you may have about risk and how it can affect your portfolio.