Anytime a person makes a decision to invest or save his money, he or she has probably formulated an expectation of how much they will get back at some time in the future. For most people, the expectation is that they will receive more than what they put in after a period of time. Some people will expect to get back no less than what they put it in, while others are willing to accept less back for the higher expectation of a greater return on their money. The difference in these attitudes and expectations is rooted in each individual’s tolerance for risk.
Risk Tolerance and Investment Expectations
While it may be a prudent action for people to invest their money with the assurance that they will receive 100% or their principal back, it comes with the expectation that the return on their money will be somewhat lower than if they had no such assurance. This is the cause and effect of a zero or low risk tolerance when investing. For people seeking a higher return on their money, they must be willing to accept a commensurate amount of risk.
Investors also need to be aware that risk presents itself in several different forms and that consideration should be given to striking the right balance and proper diversification through a mix of investments that can mitigate the overall risks of their money at work.
Types of Risk
This is, perhaps, the primary risk that most people associate with investing. Investments that are tied to a market valuation, such as stocks, bond, real estate, metals, and collectibles, are subject to price fluctuations. The nature of market risk is that it is impossible to forecast the movement of prices as they are affected by a large number of factors such as the economy, global events, politics, investor attitudes, none of which are predictable.
For investors with no or low risk tolerance, the larger risk they face is the loss of purchasing power of their invested or saved dollars. Low yielding savings instruments such as CDs, money market funds, and T-Bills, can satisfy an investor’s desire for no risk, however, when held over a long period of time, they can actually erode the purchasing power of their savings due to inflation.
Interest Rate Risk
Investment instruments that are tied to interest rates, such as corporate and government bonds, or any marketable debt instrument, are subject to price fluctuations resulting from the movement of interest rates. The values of these investments move in the opposite direction of interest rates, so that, if rates increase, the value of the investment will go down and vice-versa.
The tax treatment of earnings from all investments fall within some provision of the tax code and, it can be treated differently at the different levels of government. The tax code is subject to change and so is the tax treatment of investment earnings. Although, tax treatment shouldn’t be the primary consideration for choosing an investment, a change in the tax treatment could make the investment less suitable for your situation.
Investments that have market risk can also have liquidity risk in that an investor may not be able or willing to sell an investment that has lost value. Some investors will feel the need to hold onto an asset until it can recover its value. In some cases, an asset may not have a ready market for buying the asset at its fair market value.
When an investor buys a debt instrument (a bond or note) from a company, he undertakes the risk that the company could run into financial trouble and default on the debt.
Controlling or Reducing Risk
Investors who put all of their eggs into one basket subject their money to the highest level of exposure that is inherent in that basket, whether it is stocks, real estate, metals or CDs. By spreading investment dollars among several different types of assets, risk associated with any one asset is lessened for the total portfolio.
Investments, especially those with exposure to market risk, interest rate risk or inflation risk, should be consider as long-term commitments in order to allow them to ride through the inevitable economic and market cycles.
Establish a Liquidity Fund
By creating a secure, cash fund with sufficient monies to provide for short-term or emergency needs, one can afford to ride out market downturns.
Invest with Quality
By limiting your investment choices to companies that have demonstrative financial strength, you can reduce the risk of default or market loss due to a failed enterprise. While the stock of quality companies is always vulnerable to market downturns, the likelihood of them failing all together is less than with companies in questionable financial condition.
Investing for the reward of a return on an investment should always be considered along with the risk that is commensurate with that reward. The key is to know your tolerance level for risk and weigh it against your needs and priorities to determine if you are able to remain within your comfort zone. If you determine that, in order to be able to meet your most important needs, a higher investment return is required, apply as many risk reduction methods as you can so as to minimize your overall risk.
For more information on investment risk, please contact us today.