When you think of the word “risk,” you may get a mental picture of such activities as skydiving, race car driving, rodeos, or other similar activities that have uncertain outcomes. For investments, the word “risk” may make you think of losing your life savings on a high-risk venture such as an oil and gas drilling partnership.
But the reality is that there are many different types of investment risk. All investments carry their own types of risk. It’s important to note that no investment exists without any type of risk.
Everything Has Risk of Some Sort
There is always risk of some form inherent in every investment (and every financial instrument, for that matter), even those that are “safe.” They may have guaranteed interest and principal, but they are vulnerable to inflation.
For that matter, even cash itself has this inflation risk exposure. The key then to dealing with risk is learning how to manage it effectively.
A well-diversified portfolio will be subject to a variety of investment risks. That way a single given risk will have a much lower chance of being able to effectively disrupt the performance of an entire portfolio.
What Do You Mean by Investment Risk?
Investment risk is typically defined as the possibility that a given investment’s return will be lower than is expected. Most people also define investment risk as the chance that they will lose money on an investment.
But there are many more specific types of investment risk. Each kinds needs to be examined in its own right in order to be understood.
Here is a breakdown of the various types of investment risk and the types of investments that are subject to those risks.
Systematic vs. Unsystematic Risks
The first factor to analyze in the world of investment risk is the difference between systematic investment risk and unsystematic investment risk.
There are some investment risks that can be eliminated or minimized through adequate portfolio diversification. Meanwhile, others can’t.
Unsystematic risks can be eliminated through diversification. On the other hand, systematic risks are inherent in every portfolio. All types of investment risk fall into one of these two categories.
Types of Systematic Risks
Here are different types of systematic risk that you might encounter in some form or fashion.
This is perhaps the most obvious and well-known kind of investment risk. Market risk is the possibility that an investment will lose some or all of its value before it is sold or redeemed.
Common stock is probably the best example of an investment that has market risk. Its value rises and falls in tandem with the overall markets.
But many other kinds of assets are subject to market risk, too. Those range from commodities and currencies to mutual funds and ETFs. The value of these investments can go up or down with changing market conditions.
Interest Rate Risk
Interest rate risk is based upon the behavior of fixed-income securities in the secondary market. When interest rates rise, the price of fixed-income securities that have already been issued will fall.
Why? Because they are now worth less because the new securities that are issued will have higher coupon rates.
Therefore, in order to remain attractive to buyers, the price of the older securities must be discounted in order to make up for the difference in coupon rates. Interest rate risk is therefore the risk that the price of a fixed-income security will fall in the secondary market when interest rates rise.
All types of fixed-income securities that trade in a secondary market are subject to this risk.
Inflation risk is the possibility that the purchasing power of an investment will be eroded over time by the effects of inflation. This risk applies to most types of fixed-income securities.
Examples of these include Treasury securities, municipal and corporate bonds, CDs, bond funds, and money market funds. Even though they aren’t any sort of investment or securities product, fixed annuities also are subject to inflation risk.
One type of fixed-income security that isn’t subject to this risk is the I-bond. This is a special type of bond issued by the U.S. Treasury that pays interest that has been indexed for inflation.
Reinvestment Rate Risk
This risk also applies solely to fixed-income securities. It is the possibility that a given bond or CD will mature and then pay a lower interest rate when it is reinvested.
This type of risk applies when interest rates are falling.
This is the risk that an investor will outlive the income from their assets. The longer the projected lifespan of the investor, the greater the risk is that their portfolio holdings won’t last long enough to provide for them over their lifetime.
This type of risk does not apply to any type of specific investment. Rather, it’s more applicable to an entire investment portfolio in general.
No other instrument or investment elsewhere can do this like annuities can, period.
Here are different kinds of systematic risk that you might encounter.
This type of risk also applies only to fixed-income securities such as bonds (these securities also include preferred stocks). Credit risk is the possibility that the issuer of a fixed-income security will default and become unable to make its principal and interest payments.
Credit rating agencies such as Standard & Poor’s, Fitch’s, and Moody’s all assign credit ratings to the various issuers of fixed-income securities. The higher the rating, the lesser is the chance that the issuer will default on its obligations.
Treasury securities receive the highest ratings. After all, they are backed by the full faith and credit of the U.S. government. They are considered the “safest” investments on earth.
Credit ratings can be broken down into AAA (the safest), AA, A, BBB, BB and so on, down to F. Any fixed-income security that has a credit rating below BBB is considered to be “junk.”
Junk securities pay higher rates of interest in order to compensate for their higher rates of default. Aggressive investors seeking higher interest rates therefore invest in these securities hoping that the issuers will be able to meet their obligations.
This is the risk that the value of an investment could be adversely affected as a result of new legislation that is enacted by Congress. For example, if Congress was to revoke the tax-free status of municipal bonds, then the value of those bonds would decline in the secondary market.
All types of investments that trade in the United States are subject to this kind of risk in one form or another.
Foreign Political Risk
This type of risk only applies to investments that originate from outside the United States.
For example, if a foreign country gets invaded, then its debt obligations may become worthless. Or the government of a foreign country may increase taxes on its investments, thus lowering the yield reaped by domestic investors.
Exchange Rate Risk
This is the risk that one nation’s currency may lose value relative to other national currencies. This risk applies to every currency in circulation today, including the U.S. dollar.
This is the risk that a portfolio becomes over-concentrated in one security or type of securities. For example, a portfolio that has too much exposure to stocks could be substantially diminished in the event of a severe bear market.
This is the risk that an investment won’t be able to be liquidated if the investor needs to get their hands on some cash quickly. Annuities are good examples of instruments with relatively limited liquidity.
Most annuities have back-end surrender charge schedules that may bring a penalty to those who make substantial withdrawals from them during the early years of their contract terms.
However, most annuities do provide some liquidity in the form of free withdrawals. The point is there are other assets out there that offer more liquidity than these insurance contracts do.
Time Horizon Risk
This is the risk that an unforeseen event could shorten the time horizon of an investment or portfolio holding. For example, say an investor is hit with a major medical bill. Then they may have to liquidate a large portion of their portfolio in order to cover this cost.
This would affect the time horizon over which the portfolio could last. Furthermore, the investor may be forced to sell long-term investments when they are trading at a depressed price, thus realizing an additional loss.
This is the risk that the value of a security offered by a specific business or issuer will decline in value. If a fundamental design flaw is found in a company’s flagship product, then its stock price will most likely fall.
This is the risk that a fixed-income security may be recalled early by the issuer if interest rates fall. The issuer will build this feature into its offerings if it wants to protect itself from having to continue to pay a higher coupon rate when new securities are being issued paying lower rates.
The Importance of Diversification
Unsystematic risks can be either eliminated or drastically reduced through adequate portfolio diversification. Systematic risks can often be reduced by diversification but not eliminated.
But adequate portfolio diversification can allow you to effectively manage the amount and types of risk that you take with your money.
A mixture of different assets can provide at least a partial defense against many types of risk. Those include market risk, interest rate and reinvestment rate risk, legislative risk, foreign political risk, and exchange rate risk.
Your Risk Capacity Changes as Retirement Nears
Here is a sound rule of thumb to remember when planning for the golden years. The closer that you get to retirement, the less overall risk you can afford to take with your retirement savings.
For example, say you are invested primarily in stocks and the markets experience a major correction. It may be years before your portfolio is able to fully recover.
New Planning is Essential
Therefore, it’s prudent to ensure you aren’t overexposed to certain risks, such as market risk, as you draw near to retirement. Your financial focus should shift from portfolio growth to protection of what you have.
That way you will have enough money to live on after you stop working.
Consult your financial advisor for more information on the different risks and how they can affect you. What if you are looking for a financial professional to help you work through these “what ifs?” Or perhaps you are looking for someone to guide you in building a personalized retirement strategy.
No sweat. Many financial professionals are available via SafeMoney.com to guide and assist you. Use our “Find a Financial Professional” section to connect with someone directly. Should you need a personal referral, call us at 877.476.9723.