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Types of investment risk
Once the investment portfolio has been designed and its ability to meet the universal investment objectives measured, an evaluation of the "risk" in the portfolio needs to be done. It used to be simple to define risk as merely the loss of principal. Money stored or hidden stood the risk of thieves and erosion, whereas money invested in a bank stood the risk of bank failures. However, for most part, the risk was well-known and could be planned for. Once an investment portfolio becomes sizeable and once we introduce a worldwide and a very uncertain economic situation, the risks become far more complex and more difficult to plan for. For example:
1. A business risk. Some investments such as a real estate project or a specific stock are dependent upon the successful running of a business in order for the principal to remain intact. 2. A financial risk. Some investments will retain their relative value in times of monetary collapse or total economic or political upheaval whereas others won't. For example, during a monetary collapse, real estate and gold may retain their relative value whereas cash probably will not. Many investments, therefore, bear some financial risk.
3. Market risks. No one has total control of the market; rather we are subject to whatever market we happen to be investing in, whether it is the real estate market or the stock market or the bond market. Any investment that is part of a larger market bears a risk that is basically uncontrollable by any one individual.
4. Interest rate risk. Many investments will provide a current interest rate, but if that interest rate is fixed and interest rates for similar types of investments go up, you have borne an interest rate risk. As an investment strategy, it used to be safe to invest in long-term, nontaxable municipal bonds yielding 3%, 4%, 5% or 6%. The interest rate was known, and if you then locked that interest rate in for a long time period, you were relatively safe.
5. Pruchasing power risk. Investments in cash type investments, such as certificates of deposit, money market funds, savings accounts, Treasury Bills, among other instruments, experience a loss in purchasing poewr during times of inflation, whereas in times of deflation, they experience an increase in purchasing power.
6. Tax risk. Many investments such as tax shelters, have a risk of future assessments associated with them because the IRS may change the law of their interpretation of the law. An investment in cash probably bears no tax risk, whereas an investment in an opal mine in Brazil, yielding five to one write-off, might bear a substantial tax risk.
7. Legal risks. Certain investments may have a risk of lawsuits associated with them. For example, if you are investing in rental real estate, you certainly bear the risk of a lawsuit if someone is injured on your property.
Action Item:
Once the investment portfolio has been designed and its ability to meet the universal investment objectives measured, an evaluation of the "risk" in the portfolio needs to be done.
Today's Bottom Line
Once an investment portfolio becomes sizeable and once we introduce a worldwide and a very uncertain economic situation, the risks become far more complex and more difficult to plan for.
Adapted from Master your money textbook
