One day I was talking with a lady who shared with me she had been busy digging money out of her parent's back yard and from under their porch!! I couldn't believe it! Apparently, her father recently passed and no one in the family actually knew that her dad was burying money in the back yard, except her deceased mother. Luckily though, a family friend had overheard her mom and dad talking years prior and alerted the family that maybe they ought to start digging. I guess her dad felt the ground was the safest place for his money. If you are one of those people who like to bury your money in a jar in your backyard…guess what…your money isn't safe, you still have risk!
When it comes to assessing risk, both investors and advisors are guilty of narrowing in on one type of risk and neglecting the other areas of risk. While market risk is by far the most common form of risk, there are others that should be considered, in addition to market risk, in order to protect your portfolio. Here is a list of risks that all investors should be aware of, and advised on before making any investment decisions.
When credit is involved, there is always some kind of risk. As it pertains to bonds you may purchase, in the event that the bond issuer would default on this debt, you could lose not only your principal but also your interest income.
Market Risk is from any events that affect all investments. This can be derived from political, demographic, economic, or social trends. The only way to escape market risk is simply to hide your money! But, then you would be subject to inflation risk! It is important to note that Inflation Risk and Interest Rate Risk are components of Market Risk.
You can see inflation at work in your everyday life. If your expenses go up 4% but you only make 2% more, then you will be losing purchasing power to inflation. In addition to inflation affecting the purchasing power of your investment returns, it can also affect the profitability of the companies that you invest in.
Interest Rate Risk
Market interest rates are subject to many forces at work in the economy. For example, one of these forces is the Federal Reserve, whose job is to control our money supply. Another example would be changes in the demand for borrowed funds. In any case, the result of these forces is a change in the value of our securities and/ or the income earned on our securities. There are two elements of Interest Rate Risk: Price Risk and Reinvestment Rate Risk which are discussed next.
Any change in market interest rates typically leads to an opposite change in the value of an investment; we call this an inverse relationship. If interest rates are rising, the bond you purchased will likely decrease in value despite the fact that the creditworthiness of the issuer may not have changed.
Re-Investment Rate Risk
This form of risk can happen in a variety of investments, but a common example would be a fixed-rate, fixed-period investment. Let's say you had your money in a five-year fixed annuity with an interest rate around 5%. Because of a declining rate environment, if that annuity matured today, you would be looking at a new interest rate somewhere around 2.6%.
Taxes should be a consideration in every financial decision you make. Changes in federal and state tax laws, along with income tax rates, could drastically affect the outcome of your financial plan.
Exchange Rate Risk
If you decide to invest in foreign investments, you need to consider the exchange rates between the United States and the Country where that investment is located. Those rates could greatly increase or decrease the value of those accounts.
Liquidity is the ability to quickly convert an asset to cash with little or no loss of principal. Therefore, liquidity risk refers to the inability to sell an asset quickly or to have a near certainty as to a selling price. Liquidity is a critical concept when we evaluate the appropriateness of particular investment assets for a client's emergency reserve.
I know this can be pretty dry material, but these are real risks that everyone should know about. Instead of burying your money or sticking it under your mattress, talk to a financial professional about all the risks involved and how to achieve financial security with a balanced portfolio to meet the needs of your individual financial situation.