All investments involve some type of risk. Financial risk is the measurable uncertainty that the anticipated return will be achieved. In many instances, investment returns are directly proportional to investment risks; as risk increases, so does potential reward—and potential loss. Although investors must be willing to bear risk in order to achieve an expected return, our main goal is to help our clients manage financial risk through sound planning and financial control. We believe that familiarizing yourself with the different types of risk is the first step in learning how to manage it within your portfolio.
Below is a partial list of the more commonly encountered types of financial risk:
- Inflation risk (sometimes referred to as purchasing power risk): Refers to the risk that inflation will diminish the buying power of an investor’s assets and income.
- Interest rate risk: The possibility of the reduction of the value of a security, especially a bond, because of a rise in interest rates.
- Economic risk: The possibility that the revenue generated from a particular project will be insufficient to cover operating expenses and to repay debt obligations.
- Timing risk: The likelihood that an investor will buy or sell a security at an inopportune time. Typically, this means buying a stock at its high or selling it at its low, or buying a bond just before interest rates rise or selling a bond just before interest rates fall.
- Market risk: The tendency of an entire class of assets to move together. The value of investments may decline over a given time period simply because of economic changes or other events that impact large portions of the market.
- Liquidity risk: The possibility that an investor will be unable to quickly convert a commodity or a security to cash without loss of principal.
- Country risk: The potential volatility of foreign stock, or the potential default of foreign government bonds, due to political/financial events.
- Reinvestment rate risk: The possibility that interest or dividends earned from an investment may not be able to be reinvested in such a way that they earn the same rate of return as the invested funds that generated them.
- Principal risk: The likelihood that the value of the amount invested will decline due to bankruptcy or default.
- Currency (exchange rate) risk: The risk that an investment’s value will be affected by changes in exchange rates. If money must be converted into a foreign currency in order to make a particular investment, changes in the value of the currency in relation to the U.S. dollar will affect the total loss or gain on the investment when currency is converted back. This source of risk applies only if the investor acquires foreign assets denominated in foreign currency. But, because investors may acquire shares in domestic firms with foreign operations or shares in mutual funds that make foreign investments, the investors may still indirectly bear currency risk.
- Credit risk: The risk that a company or an individual will be unable to pay the contractual interest or principal on its debt obligations. This type of risk is of particular concern to investors who hold bonds within their portfolios. Government bonds, especially those issued by the federal government, have had the least amount of default risk and least amount of returns, while corporate bonds tend to have the highest amount of default risk but also higher interest rates. Bonds with lower chances of default are considered to be investment-grade, and bonds with higher chances are considered to be junk bonds.
Cahill & Associates Financial Services, LLC