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When my clients ask how much risk is
involved in a particular investment, they often are referring to principal risk. This is
perfectly natural since most of us are interested in protecting our investment capital.
There are other kinds of risk, however, and it's important to understand how each might
affect an investment. The following are broad categories of risk to consider when you are
reviewing an investment:
- Inflation Risk. Inflation risk is the danger that rising prices will,
over time, reduce the purchasing power and the real rate of return of your investment. For
example, when safety of principle is the only consideration and your portfolio is limited
to high-quality, fixed-income investments (such as U.S. Treasury securities), you enjoy a
high degree of safety. At the same time, such a strategy also subjects you to a high
degree of purchasing-power risk because investments with a fixed rate of return may not be
able to keep pace with inflation.
- Interest-rate risk. Interest-rate risk is the possibility that interest
rates may climb after you have invested and have locked in a rate of return. For example,
when interest rates rise, the value of fixed-rate investments, such as bonds, tend to
fall. Why would anyone want to buy your bond at five percent when new bonds are
available at seven percent?
- Market Risk. Market risk is the chance that a market downturn could
lower the trading value of your securities. In the event of a downturn, a market
tends to pull all of its securities down with it. If the company in which you own stock is
sound, its price should eventually recover. If you were forced to sell any of your shares
during the downturn, however, the result could be a loss of capital. When it comes to
stocks, it's always good to remember that long-term investors are usually the most
successful.
- Economic Risk. Economic risk is the danger that a downturn or other
significant development in the economy will depress the value of your investments by
reducing earnings capability. While some industries and companies are able to respond well
to changes in the economy, others (particularly large industrial companies) take longer to
react. Since the ability to react can affect a company's income, it can also affect the
price of its stock.
Does the fact that there are risks involved mean you shouldn't invest? Certainly not.
But the more you understand about the risks involved in an investment, the better decision
you will be able to make.
Susan Posey is an Investment Consultant
with IJL Wachovia in Columbus, Georgia. IJL Wachovia, a division of Wachovia
Securities, Inc., is one of the nation's largest regional full service brokerage firms,
offering a full range of investment services to investors. |
