The month of October is when many of us relish the chance to be scared by ghosts, goblins, skeletons, and other things that go bump in the night. While some find that sort of good-natured fright enjoyable, no one want to be scared about their investment portfolio. Many of our clients tell us that they want their investments to be low risk. When they say this, they are almost always talking about the risk that an investment could lose money, but there are many types of risk that an investment portfolio faces.
The most obvious type of risk, and the one most folks think of, is principal risk. This is the risk that your investment will lose money – that your principal will go down in value. We tend to associate this type of risk with stock market investments, but it’s possible to lose principal on fixed income investments too. Bonds fluctuate in value based on levels of interest rates on similar bonds, and if you need to sell your bond before it matures, you could lose money.
While many investors tend to think of fixed income investments as less risky than stock investments, fixed income investments face a variety of other risks as well. One such risk is interest rate risk. This is the possibility that when your bond (or CD, or other fixed income instrument) matures, interest rates will be lower. This has been a major problem over the last few years, especially for retirees. If you are using the income from your investments to live on, lower interest rates mean that you’ll have fewer dollars to spend. Some types of bond investments face credit risk, also known as default risk, as well. This is the risk that the issuer won’t be able to pay the interest or principal on a bond when it is due. We usually associate this type of risk with corporate bonds, but other issuers sometimes default as well.
Another important risk to be aware of is inflation risk. Inflation risk is the possibility that the purchasing power of your money will decrease over time. For example, if you buy a 20-year bond for $10,000, the cost of living may double during the term of that bond. Should that happen, you’ll get $10,000 back at maturity. However, that $10,000 will only have half the purchasing power it did when you bought the bond.
Stock investments face their own risks as well. One such risk is market risk. In the long run, the financial performance of a company should determine how well its stock performs. However, over shorter periods, the performance of the stock market in general can affect the value of stock. In other words, even if a company is doing well, its stock may decline in value simply because the overall market is doing poorly.
Liquidity risk affect all types of investments. This is the possibility that if you want to sell your investment you won’t be able to find a buyer. Many stocks and bonds are very liquid, trading daily on orderly markets and exchanges. Others are traded only rarely. Also, if you have a large position in a particular investment, it may be harder to find a buyer. Some investments, like real estate or privately held businesses are very illiquid and take weeks, months or even years to sell.
This is not an exhaustive list of all the risks investors face. No one investment or even portfolio will account for all the possible risks. Having an asset allocation plan and investing in a diverse portfolio of assets may help to address some of the important risks. Regardless, it is important to develop an understanding of the risks posed by different investments and how each will affect the overall portfolio.
For more information, you can listen to the podcast of Smart Money Management radio show on this topic, along with others, at www.alderferbergen.com.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
Asset allocation does not ensure a profit or protect against loss.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
Alderfer Bergen & Co. and LPL Financial do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.
All investing involves risk including loss of principal. No strategy assures success or protects against loss.
CDs are FDIC insured to specific limits and offer a fixed rate of return if held to maturity.
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