Investing and risk go hand-and-hand, and generally speaking, the more risky an investment is, the greater the potential return. Different investments have different types of risk. Some risk can be eliminated or at least minimized through diversification, but there is an inherent risk in investing regardless of which type of investment you choose. Diversification does not assure a profit or protect against market loss. All investments involve risk, including possible loss of principal.
With that in mind, let’s explore some of the types of risk that can affect your investments.
Market risk refers to potential losses investors can experience from factors influencing the overall performance of financial markets. Also known as systematic risk, it is the risk investors are exposed to when investing in financial markets.
This type of risk cannot be eliminated through diversification, because sources of market risk can impact financial markets as a whole. Some sources of market risk include economic recessions and depressions, natural disasters, terrorist attacks and political turmoil.
Just look back to last year with the Brexit vote in the United Kingdom and the tumultuous presidential election in the United States. Both events had an impact on a global scale and had the potential to influence financial markets.
Interest Rate Risk
Many investors have heard the general rule that interest rates have an inverse relationship to bond prices. When interest rates rise, bond prices fall and vice versa. This is a prime example of interest rate risk. Interest rate risk is the risk associated with a change in interests rates.
When we talk about “interest rates” in this discussion, we are referring to the federal funds rate set by the Federal Open Market Committee and the federal discount rate set by the Federal Reserve’s Board of Governors. Interest rate risk can have an impact on investments such as stocks, but it is a significant risk to fixed-income securities like bonds.
Let’s say you have a $1,000 bond, and the coupon rate, the rate of interest the bond pays annually, is 5%. If interest rates rise to 6%, new bonds will be issued at a higher coupon rate. This makes the $1,000 bond you have less attractive to investors, because they can get a higher rate with a new bond. You would need to discount the price of your bond so the return matches what investors can get in the current market. If interest rates fall to 4%, your bond will be offering a higher interest rate than a newly issued bond, so you would be able to get a premium price for the bond.
Investors can manage interest rate risk with products like forwards, futures, swaps and options contracts. For example, a forward contract allows one party to buy or sell an asset at a set price in the future. This can be a useful tool in hedging against interest rate swings. Keep in mind there are still costs and risks associated with these products.
Call and Reinvestment Risks
Call risk is linked to callable bonds. An issuer of a callable bond will redeem the bond prior to its maturity if interest rates drop below the coupon rate of the bond. The issuer will want to refinance the debt at a lower interest rate by issuing a new bond with a lower coupon rate.
Callable bonds generally pay a higher coupon rate than non-callable bonds, but if the bond is called, the investor might end up losing potential income if reinvesting at a lower interest rate. This reinvestment risk, which is most often associated with callable bonds, is the possibility cash flows from one investment will have to be reinvested at a lower rate of return.
When a lending institution gives out a loan, there is always a chance the borrower, for whatever reason, could default on the loan. This risk, known as credit risk, represents the possibility a lender will lose the interest, principal or both interest and principal associated with the loan.
Bonds also have an element of credit risk for investors, because the government or company that issues the bond could potentially default on what is essentially a loan from the investor. Investors in bonds can limit their exposure to credit risk by investing in companies or government entities that are highly rated by reputable rating agencies.
Many investments such as real estate and other long-term illiquid assets are subject to liquidity risk. Liquidity risk relates to assets that generally can’t be bought and sold quickly at market value. If an investor needs to quickly convert an asset to cash, the investor may be forced to sell that asset below market value or at a loss.
If a homeowner needs to immediately sell his or her property in a down market, there is a risk the homeowner will have to sell the property for less than the market value. Investors can protect themselves against liquidity risk by ensuring they have sufficient cash and cash equivalent assets to cover short-term financial needs.
Business risk is the potential risk a company will have lower than expected profits or experience a loss. This risk is related to the company’s ability to deliver acceptable returns to investors. There are different types of business risk, and there are several factors that influence this type of risk including sales, costs, competition and government regulation. This type of risk can be managed through diversification.
Inflation is the general rising of the price for goods and services over a period of time. Inflation poses a risk to investors, because it reduces purchasing power and in turn can eat away at the real rate of return of investments. Let’s say an investor wants to purchase a car for $20,000. Over the next year, the investor saves $20,000 for the purchase, but inflation over that same time period increases by 3%. At the end of the year, the price has increased to $20,600 due to inflation. Now let’s say the car buyer decided to invest that $20,000 at the beginning of the year and earns a 5% nominal return during the year. The investor would have $21,000, but with inflation, the investor’s real rate of return would be 2%.
The best hedge against inflation is implementing a long-term investment strategy, because inflation can be difficult to manage short-term. Also, keep in mind bonds tend to be more susceptible to high inflation than investments like stocks.
Currency risk, also known as exchange-rate risk, applies to the relationships between different currencies and the changes in price of one currency in relation to the other. This risk mainly impacts investments in foreign markets.
An investor in the United States with stocks in Japan is not only exposed to risks associated with owning the stocks but also to the exchange rate when converting the returns from the Japanese yen to U.S. dollars. If the investor sees a 10% return on the Japanese stocks but the yen depreciates 5% against the dollar, the investor will essentially see a return of 5%. Investors can protect themselves against currency risk by choosing investments in countries with currencies that are strong against the U.S. dollar.
The political climate of a country can have an impact on markets, and factors such as regulation, laws, taxes, instability and changes in government leadership can contribute to political risk. An example of political risk would include a foreign government imposing a tariff on imports of a product or from a country. The tariffs raise the price of the product, which in turn could have a negative impact on the companies exporting that product. As with business risk, this risk can be mitigated through diversification.
Authored by: Dennis Culver, Insight Wealth Strategies