Isn’t it true that we tend to overlook the investment risk involved with particular investments? We often tend to focus on the positive aspects of investing: how much income an investment generates and how much a particular asset has appreciated in value. But investment risk is an important concept to understand and appreciate, so that you can match your level of risk to your needs.
Identify your investment risks
There is volatility and risk in every type of investment. You might think that federally insured and guaranteed investments (such as bank certificates of deposit) are 100% risk-free. But even these have some risk: namely, the risk in loss of purchasing power and an interest rate risk.
In addition to the risks that are inherent in any individual company (is the company’s business plan solid, are its managers experienced, etc.), below is a list of common investment risks. You must work to identify and quantify those that may apply to the investments currently in your portfolio:
- Investment risk #1: interest rate risk. Interest rate risk is the risk that the value of your asset will go down because of changes in interest rates. For example, a corporate bond will generally decline in value as the interest rates that apply to newly issued bonds go up.
- Investment risk #2: credit risk. Credit risk is the risk (generally in the context of debt instruments) that the borrower won’t be able to make its scheduled interest payments or to repay the underlying debt at the time of maturity.
- Investment risk #3: currency risk. Currency risk is the risk that the value of an investment declines because it does business in countries that use a different currency from the U.S. dollar, and the exchange rates between that currency and the dollar move in a direction that reduces that investment’s value in dollars.
- Investment risk #4: inflation risk. Inflation risk is the risk that an increase in the cost of living reduces the purchasing power of your asset in real terms.
- Investment risk #5: political risk. Political risk is the risk that your investment will be affected by political events, particularly when that investment does a significant amount of its business outside the U.S.
Identify your own investment risk tolerance
What are your current investing goals? If you’re near or already in retirement then chances are you have a much lower appetite for risk because you need your retirement nest egg to be safe above all else. If you’re 25 years old, then you have more time to bear the potential consequences of risky investments.
But your investment risk tolerance is also a matter of personality. What type of investor are you? Do you tend to gravitate toward investments that have relatively low levels of risk, or do you seek out riskier investments in a search for higher levels of return? Which type of outcome do you find more unpleasant: having one of your riskier investments decline in value, or missing out on a possible large gain by choosing a safer investment over a riskier one?
By comparing your expectations and personal risk tolerance with your portolio’s current composition, you’re more likely to choose investments that are the best fit for your individual needs.
Quest Trust Company helps change people’s lives and financial future throughself-directed IRA investment education. Quest Trust Company helps people invest in what they know best and build their financial future on their own terms.