Risk is an inherent part of investing. Generally, investors must take greater risks to
achieve greater returns. Those who do not tolerate risk very well have a relatively smaller
chance of making high earnings than do those with a higher tolerance for risk.
In order to understand the different types of risk, we have broken them down into these levels:
PERSONAL RISKS
This category of risk deals with the personal level of investing. The investor is likely
to have more control over this type of risk compared to others.
Timing risk is the risk of buying the right security at the wrong time.
It also refers to selling the right security at the wrong time. For example, there is the
chance that a few days after you sell a stock it will go up several dollars in value.
There is no surefire way to time the market.
Tenure risk is the risk of losing money while holding onto a security.
During the period of holding, markets may go down, inflation may worsen, or a company may go bankrupt.
There is always the possibility of loss on the company-wide level, too. Click here to learn more.
COMPANY RISKS
There are two common risks on the company-wide level. The first, financial risk,
is the danger that a corporation will not be able to repay its debts. This has a great effect
on its bonds, which finance the company's assets. The more assets financed by debts
(i.e., bonds and money market instruments), the greater the risk. Studying financial risk involves
looking at a company's management, its leadership style, and its credit history.
Management risk is the risk that a company's management may run the company so poorly
that it is unable to grow in value or pay dividends to its shareholders. This greatly affects
the value of its stock and the attractiveness of all the securities it issues to investors.
MARKET RISKS
Fluctuation in the market as a whole may be caused by the following risks.
Market risk is the chance that the entire market will decline, thus affecting the prices
and values of securities. Market risk, in turn, is influenced by outside factors such as
embargoes and interest rate changes see Political Risk below.
Liquidity risk is the risk that an investment, when converted to cash, will experience loss
in its value.
Interest rate risk is the risk that interest rates will rise, resulting in a current
investment's loss of value. A bondholder, for example, may hold a bond earning 6% interest
and then see rates on that type of bond climb to 7%.
Inflation risk is the danger that the dollars one invests will buy less in the future because
prices of consumer goods rise. When the rate of inflation rises, investments have less purchasing power.
This is especially true with investments that earn fixed rates of return. As long as they are held at
constant rates, they are threatened by inflation. Inflation risk is tied to interest rate risk, because
interest rates often rise to compensate for inflation.
Exchange rate risk is the chance that a nation's currency will lose value when exchanged for
foreign currencies.
Reinvestment risk is the danger that reinvested money will fetch returns lower than those earned before reinvestment. Individuals with dividend-reinvestment plans are a group subject to this risk. Bondholders are another.
NATIONAL AND INTERNATIONAL RISKS
National and world events can have profound effects on investment markets.
Economic risk is the danger that the economy as a whole will perform poorly.
When the whole economy experiences a downturn, it affects stock prices, the job market,
and the prices of consumer products.
Industry risk is the chance that a specific industry will perform poorly. When problems
plague one industry, they affect the individual businesses involved as well as the securities
issued by those businesses. They may also cross over into other industries. For example, after a
national downturn in auto sales, the steel industry may suffer financially.
Tax risk is the danger that rising taxes will make investing less attractive. In general,
nations with relatively low tax rates, such as the United States, are popular places for
entrepreneurial activities. Businesses that are taxed heavily have less money available for
research, expansion and even dividend payments. Taxes are also levied on capital gains, dividends
and interest. Investors continually seek investments that provide the greatest net after-tax returns.
Political risk is the danger that government legislation will have an adverse effect
on investment. This can be in the form of high taxes, prohibitive licensing, or the appointment
of individuals whose policies interfere with investment growth. Political risks include wars, changes
in government leadership, and politically motivated embargoes.
This concludes our look at the major risks of investing.
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