It feels like right now there are a lot of sticks in the fire that could cause some big changes for our world, and for our investments. This is why it is important to discuss the different types of investment risks you need to consider, especially during this time of uncertainty due to the possibility of a COVID vaccine, economic impact of the virus into 2021 and beyond, a stimulus package, the direction of our federal government initiatives, inflation and interest rates, along with other items.
It’s been a big year, as we all can feel.
When I look at an investment portfolio and a financial plan, a big thing I look at is the risk my client is taking. A lot of times when we think of risk, we just think about the level of equities versus bonds we have in the portfolio.
While that is absolutely a way of measuring risk, there are deeper layers to look at. Everyone thinking about investing must understand the different types of investment risks.
I have talked about this in a few other articles, but I wanted to focus on specifically the different types of investment risks that could affect someone’s financial well-being, and give you some ideas to think about or speak with an advisor about.
So, what are the different types of investment risks?
One of the different types of investment risks is market risk. This is the risk that the value of your portfolio, aka your investment returns, will fluctuate based on macroeconomic factors, such as recessions, politics, currencies, overall economic impact. It is the risk we see the most when we look at our account balances. There are many factors that are a part of market risk.
On the flip side, inflation risk is the risk you lose purchasing power if your investment returns do not keep up with inflation. Think of cash for example – while cash is a great tool to have, it’s important to balance this with the rest of your portfolio as your cash is earning close to nothing and therefore could be losing purchasing power.
While it’s nice to see your cash balance stay at relatively the same level, you also may be losing money if inflation is increasing.
Another example of the different types of investment risks is the risk of not being able to sell securities and convert them to cash. For example, an ETF or a stock typically has high liquidity, as you can sell that stock and have cash within 1-2 business days.
An investment property on the other hand has a higher liquidity risk as it takes more time to sell that property and convert to cash. You have to wait for an interested buyer, and wait for the sale to close. Many forget about this risk – and assume that when the time comes, these properties will sell immediately, which isn’t always the case.
Interest Rate Risk
Interest rate risk is the risk that your investments fluctuate with interest rates. We see this with bonds – typically when interest rates rise, the value of your bond goes down. Vice versa if interest rates fall.
If you plan to hold your bond until it matures, that risk doesn’t affect you as much. If you need to sell your bond and the value is now lower, you are going to end up taking a loss on it.
One of the different types of investment risks that is definitely one everyone’s mind as of the time of writing this is political risk.
Political risk is the risk that the political environment of the country will negatively affect performance and therefore the stock value. For instance, if candidate X gets elected they may choose to pass Bill Y that will have effect Z on the economy.
Many of us are weighing this risk right now, which I will go into detail in another article this month.
Business risk is the overall uncertainty of a business’s operations (i.e. is the company a going concern?), and whether they are sustainable/profitable. This is a risk evaluated heavily with startups or new companies, but can apply to any operating company.
This is the risk that the company that owns your bond no longer can pay it’s debts. Each bond has a credit rating tied to the company that issues it to help give a gauge on this risk, but credit ratings can change after someone purchases a bond, and have either a positive or negative effect on its current market price.
Different Types of Investment Risks – Financial Planning Specific Risks
Financial planning risks are another type of investment risk that must be considered. These are risks that are particular to you and have to do with age, willingness to invest, and much more. Below are three important financial planning risks that compliment the different types of investment risk.
Longevity risk is the risk that you outlive your money. This is something I plan for with every client – as its imperative to assume longevity.
The risk that an intended time horizon changes. For example, if you lose your job and no longer have the income you are anticipating. Within a financial plan, we try to bridge these risks with other measures.
This type of investment risk is probably on everyone’s mind right now considering what is going on in the world. Specifically, health risk is the risk of your health deteriorating and costs associated with health concerns increasing. This is also an important measure to consider, especially for older folks.
Different Types of Investment Risks – Summary
While everyone has a different level of comfort with the risk they are taking, it’s important to be aware of exactly how much risk is there. Although it is great if you understand the different types of investment risks, it is really up your financial/investment planner/advisor to help you manage them.
If you have any questions on this, feel free to reach out or leave a comment below.
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Opinions voiced in this article are for general information only and are not intended to provide specific advice or recommendations. To determine which investment may be appropriate for you, consult with your attorney, accountant, or financial advisor prior to investing.
Information and interactive calculators are made available to you as self-help tools for your independent use and are not intended to provide investment, tax, or legal advice. We cannot and do not guarantee their applicability or accuracy in regards to your individual circumstances. All examples are hypothetical and are for illustrative purposes. We encourage you to seek personalized advice from qualified professionals regarding all personal finance issues.