Understanding the Risks of Investing
Everyone knows that investing money is never risk-free. The idea is for you to find the investments that offer the best chance for a good return, with the least amount of risk, and that takes some know-how. Some risk affects only a particular business or industry, and is called unsystematic risk. Risk that affects the entire market is called systematic risk. Both are to be managed by diversification.
First of all, there are all kinds of investment risk. The following are just some of the different types:
- Business risk This risk comes from the way in which the business that issued the security is managed. Will it be in business in three years? Does it have a marketable product? To get some perspective on business risk, talk to somebody who invested in a dot.com company back in the late 1990s. Many of those companies are now nonexistent or worth less than $5 per share of stock.
- Financial risk This risk is associated with the finances of the company. Does it have too much debt (the recent declaration of bankruptcy by Enron is a prime example), or does the company spend too much on new technology?
- Purchasing power risk This risk is the effect that inflation might have on the value of your holding. When your 30-year, $10,000 corporate note matures, how much will $10,000 truly be worth? If there's been high inflation over those 30 years, your bond won't be worth as much in current dollars as if inflation had been low.
Show Me the Money
The type of risk that affects the entire market is called systematic risk. The kind of risk that affects only a single business or industry is called unsystematic risk.
- Interest rate risk This risk involves how changes in interest rates may affect yourinvestment.
- Market risk This risk reflects the tendency for stock to move with the market or entire industrial group or for a particular security, as a result of factors such as economic, political, or social events—also known as systematic risk.
- Default risk This risk is the chance that the company you've invested in will be unable to service the debt.
- Foreign currency risk This risk is that a change in the relationship between the value of the U.S. dollar and the value of the currency of the country in which your investment is held will affect your holding. This is an important risk for international investing. Just ask anyone who's had money in a Thai or Rus-sian fund during the past year. Ouch!
Reading all those possibilities for risk can be scary, but you must understand as much about risk as possible. The key thing to understand is exactly how great these risks are and where they are most likely to occur.
For most beginning investors, until recently, the stock market has been a pretty tempting place. Now it's a pretty scary place. In the past, everybody knew stocks really paid off, right? In the long run, they usually do. Even when the stock market is down, as it was from 2000 to 2002, many financial advisors recommend buying stocks (either via individual stocks or via equity mutual funds) if you're planning to invest over a long period of time. If you can't leave your money invested for a long period of time, however, then stocks might not be the best investment for you.
Dollars and Sense
Mutual funds often offer built-in diversification, which makes them an attractive option to many investors. As you get to know your way around the investment arena a little bit better, you can pick and choose your own diversified investments. When you're a beginning investor, however, mutual funds make good sense.
The stock market is subject to some pretty significant fluctuations and involves many possibilities for risk. Just look at the way the market plunged after the 9/11 terrorist attacks, as investor confidence plunged right down to Ground Zero. Even now, four years later, the market is unstable due to war in Iraq, record-high worldwide oil prices, shaky job growth, and other factors. Still, if you can put your money in and ride it out for the long haul, you'll probably do okay. But if you have a limited period in which to leave your money in stocks, you risk having to take it out at a time when the market is down, such as it is currently. If that happens, you'll lose money. Investments in real estate carry similar risks. The real estate market can be great, or it can drop pretty dramatically.
On the other hand, if you invest in something extra safe, you're almost assured to get a lower return, at least when interest rates are as low as they are today. Investors want to be rewarded for the risks they take, so junk bonds must pay a higher yield than Treasuries and so forth. If it's feasible for you to have your money invested for a long time, then stocks are probably a better investment than low-risk, low-yield bonds.
Probably the best way of controlling risk, as far as your investments are concerned, is through diversification. When you diversify, you put your money into different investments so that if the value of some of them decreases, the value of the others is likely to be high enough to keep your investments stable.
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Excerpted from The Complete Idiot's Guide to Personal Finance in your 20s and 30s © 2005 by Susan Shelly and Sarah Young Fisher. All rights reserved including the right of reproduction in whole or in part in any form. Used by arrangement with Alpha Books, a member of Penguin Group (USA) Inc.
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