Investment Risk


All investments have risks, some more than others.

When you invest, you always take on a certain amount of risk. At the very worst, you could lose all the money you invested. That can be the case with stock in a company that goes bankrupt, with bonds that default, and with certain speculative ventures. Or, your return on investment — what you get back for what you put in — could be so small it doesn’t really count as an investment at all. At the very best, you could invest a small amount in a growing company and make a fortune. And between those extremes you have enormous investing choice.

Before you invest, you have to know what the potential risks are as well as your own level of risk tolerance. For example, if a falling stock market makes you lose sleep or, worse yet, if you know you’d sell in a panic, stocks may not be the investment for you. On the other hand, investing too conservatively poses the real risk of not earning enough to beat inflation.


Investment Risk Pyramid



ESTIMATING RISK

There’s no way to predict how investments will perform in the future or the risks that may limit their return. But by looking at the way that an investment or category of investments has performed in the past, you can get a sense of the level of return that may be possible and also what is out of reach.

For example, if the average pretax return on large company stocks, as measured by the S&P 500 stock index, was 10.4% between 1926 and year-end 2007, it’s unrealistic to assume that future returns will average 20% or more despite the fact that they have been that high or higher in individual years. In other years, the average return has been significantly lower, including years when stocks have lost value.



OTHER KINDS OF RISK

Beyond the risks of the investments themselves — for example, a new company that fails or an established company that suffers severe losses — there are other risks you can’t predict or control but must be prepared for:

MARKET RISK depends on the state of the economy as a whole. If the stock market tumbles, your stock investment will probably decline in value even if the company whose stock you own is making money.

CURRENCY FLUCTUATION is increasingly a factor in investment risk, as more people put money into international markets, especially in mutual funds. As the dollar rises in value, for example, the value of overseas investments declines — and vice versa.

INFLATION RISK affects the value of fixed-rate investments, such as bonds and CDs. If you buy when interest rates are low, the value of your investments declines as the rate rises because the interest rate on existing investments isn’t adjusted to keep pace.

POLITICAL TURMOIL is a risk because the economies of different nations are closely intertwined. That means instability in one area can have a ripple effect around the world.



KEEPING YOUR EYES CLOSED

The worst mistakes you can make as an investor are to ignore what’s happening in your portfolio, minimize the risks you’re taking, and to assume that nothing is going to go wrong. By recognizing that very risky investments, like futures contracts, can cost you even more money than you originally invest, you might decide not to try your hand at them. Similarly, you have to be aware of the risk involved in investing all your money, or even a sizable percentage of it, in one place.

You also have to be alert to advisers who swear that an investment is risk free. It’s probably fair to say that the more they promise, the greater the risk they’re asking you to take. The one investment that may fit in the risk-free category is the 13-week US Treasury bill, also called the 90-day bill, provided that you hold it to maturity.


THE SECURITY OF INSURANCE

One of the reasons people feel comfortable about putting money into bank products — like CDs, money market accounts, and regular savings — is that their investments are insured through the Federal Deposit Insurance Corporation (FDIC). If the bank folds, the money is safe.

Unfortunately, it’s not that simple. If a bank is bought out by another bank — a growing phenomenon as large regional banks expand — the money will be safe, but the rates depositors had been earning might not be. For example, a bank that acquires another bank is under no obligation to pay the same CD rates when you reinvest that were paid by the bank it bought. And the new bank can change the rates on savings or money market accounts at any time.

Equally important is understanding how much insurance the FDIC provides. Basically, it insures you up to $250,000 per account category in each bank. The five categories that most people use are individual, joint, trust, retirement, and business accounts. For example, if you had an individual account and an IRA, each of them would be covered up to $250,000.

But if you had $500,000 in two individual accounts, only $250,000 would be covered. Accounts in separate branches of the same bank are considered one account, but if you have individual accounts in two different banks, both are covered up to $250,000.


THE RISK OF HIGH YIELDS

One cardinal rule for successful investing is to know what you’re doing. When the economy is down, and interest earnings decline, you might be tempted to seek an investment that produces the same high returns to which you’ve grown accustomed. The risk is buying lower quality investments, which pay more to attract buyers, or investments you don’t really understand. Derivative products, such as collateralized debt obligations (CDOs), for example, are complex and may be riskier than they seem, despite the promise of a high yield and the comfort of a familiar sounding word: mortgage.


PLAYING IT TOO SAFE

You won’t lose your shirt with low-risk investments. But you might not earn enough from them to buy a new shirt when your old one wears out. Trying to avoid risk by investing in only the safest products is a mistake, especially if your retirement is a long way off. If that’s your current approach, though, you’re not alone.

Lots of Americans have most of their retirement money in investments that aren’t beating inflation. One solution is to diversify the types of risk you take by making a variety of investments.