The True Risk of Investing: Understanding the Types of Investment Risk

So many people are weary of investing right now because of everything that has happened with the economy recently. I think a lot of the trepidation has been driven by the sensationalist media coverage. The Dow dropping 500 points in one day becomes a front page headline and people who have no clue what they’re talking about ramble on about double dip recessions and the decline of America. The next day the Dow rises back to where is was the day before and all is well again.

The daily fluctuations of a market index like the Dow don’t mean anything. Yet every news cast reports the change in the Dow and other indices every evening. People see these huge swings and think – I better pull my money out of the market and sit on the cash. It’s too risky right now.

The thing is, when you’re investing for the long term it doesn’t really matter what the market is doing right now. In fact, I love investing in a down market. That means I get to buy at a discount!

You need to be smart when investing. You need to understand exactly what the risks are. By understanding the risks you can make better decisions about investing while mitigating risk.

Inflation Risk

The risk that the purchasing power of your assets will decrease over time. I talked about this in my last post. Inflation can turn the most conservative investments into some of the worst investments.

If your investment is not growing at a rate that exceeds inflation, your investment is actually losing value over time.

Over the last 47 years, the value of one dollar has declined 86%. It now takes $7 to buy what $1 would buy in the 1965. If you stashed $10,000 under the mattress in the mid 1960’s – it would have the same purchasing power as $1,500 today.

Reinvestment Risk

The risk that when your current investment matures you will be unable to reinvest the proceeds at a similar rate of return. Reinvestment risk can also refer to the risk that your will be unable to reinvest the cash flow from your investment at a similar rate of return.

Traditionally, this type of risk has been associated with bonds. Specifically it is the risk that coupon payments could not be invested at a similar rate of return.

However, this is applicable to all type of investments that you ever intend to receive some type of proceeds on. Whenever you sell an investment, there is a risk that you will be unable to put those funds to work at a similar or better rate of return.

Systematic Risk (Market Risk)

The risk that a major economic or political event will cause the value of your investment to decline. This is one of the most pervasive risks that is very difficult to mitigate.

We’ve seen a great example of this type of risk with the European Debt Crisis. Whenever good news or bad news is released, the market can swing wildly up or down. It’s difficult to mitigate this risk as it effects the entire market. It’s not impossible as you can use hedges, shorts, covered calls or investments with a negative beta, but those aren’t the simplest of instruments to understand and use.

Currency Risk

The risk that the value of the currency in which your investment is denominated will decline.

This generally applies to investments denominated in a foreign currency, but also technically applies to domestic investments. The most obvious time you would face this risk is if you hold foreign investments. Not only do you face the risk that those investments could decline, you also face the risk that the value of the currency those investments are in will decline in relation to your own currency.

For example, if you hold bonds denominated in Euros there is a risk that the Euro will be worth less when your bonds mature. If it declines, you risk losing money even though the value of your investment actually went up.

It can also affect domestic investments as the value of your home currency in relation to other currencies has a broad effect on the market and the economy as a whole.

Liquidity Risk

The risk that you will be unable to sell your investment quickly enough to prevent a loss.

While applicable to all investments, a lot of people have recently experienced this in the real estate market. As housing values began to decline, many who had homes on the market could do nothing but sit and watch as prices plummeted. Many sold their homes at a loss because they could not sell quickly enough.

Other examples of this are equities with low trading volume and investments with a limited secondary market such as artwork.

Dealing With Risk

All of this doesn’t mean that you shouldn’t invest. Far from it. You just need to understand what the actual risks are when choosing investments. When you understand the risk then you can better mitigate the risk. You can also make better decisions as to whether the expected return is appropriate for the true level of risk you are facing.