Ask the Advisor – 10/30/2007
Here’s the first of many installments written by the Hoboken411 Financial Advisor. Today’s piece is about the various investment risks.
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Knowing Risk. Wall Street Gambles or Vegas Shambles?
The word “risk” is not something that conjures up a pleasant image in the minds of most investors. Many people don’t like risk. Unfortunately, risk is unavoidable. If you invest for profit, you face the possibility of suffering a loss; and if you invest too cautiously, you run the risk of earning a return that will not keep pace with inflation. If you veer the subject completely and head to whichever gaming grounds you’re geographically closest to, chances are you’ll be tempted to spoil what riches you have won, give in to your existing vices, create new ones and spend lavishly on the luscious temptations that surround you.
One of the best ways to become comfortable with risk is to take a brief amount of time to understand it. The more familiar you are with it, the better position you will be in to create a balance between risk and potential reward in your portfolio. Below is a description of three distinct types of risk that you can face as an investor and how you can deal with each kind of risk: Market Risk, Inflation Risk and Interest Rate Risk.
Read much more about them after the jump.
Ask the Advisor (continued)
Market risk refers to the fact that your investment could go down in value and, therefore, be worth less than your purchase price. Any number of factors can affect an investment’s valuation. For example, disappointing earnings can cause a company’s stock price to decline. Rising interest rates can trigger a drop in the price of a bond.
The best way to reduce the effect of market risk in your portfolio is to diversify your assets among securities that are likely to perform differently in the same market environment. In this way, the positive performance of one security can help to offset the negative performance of another.
A good first step in creating a diversified portfolio is to spread assets among stocks and bonds or the mutual funds that invest primarily in these securities. While past performance is no guarantee of future results, stocks and bonds often perform differently under the same market and economic conditions.
For example, if the economy shows strength after a period of weakness, stocks tend to do well, but bonds prices tend to fall because interest rates usually move higher. Similarly, when interest rates decline on economic weakness, bonds typically do well, but stocks tend to fall as investors become concerned about the overall outlook for corporate earnings.
Although diversification can help limit risk, it can also limit your potential for gains. For example, if the stock market soars, you could enjoy large gains if you had a substantial portion of your portfolio in equities. But if most of your assets were spread across a wide range of non-equity-related investments, your gains may be limited.
Inflation risk refers to the idea that the return from an investment may be less than the inflation rate, the increase in the cost of living. While earning a return that is lower than inflation may not appear to be significant, it could prove hazardous to your financial health if it occurs over a period of years.
This is because when you earn a return that is lower than inflation, your dollars lose purchasing power. This means you will need to spend more money to buy the same amount of goods and services that you bought in the previous year. If this trend continues over time, it could affect your standard of living.
To counter inflation risk, you need to buy securities with the potential to deliver returns that exceed the increases in the cost of living. Although past performance is no guarantee of future results, equities have had the best record of outpacing inflation (and casinos) since 1926.
Interest Rate Risk
The valuations of fixed-income investments, such as bonds and preferred stock, are affected by interest rates. When rates rise, overall valuations of fixed-income securities usually decline. Conversely, when interest rates decline, valuations of fixed-income securities typically rise.
The degree by which fixed-income securities are affected by interest rates usually depends on their maturity (the number of years before principal is supposed to be returned to the investor). Generally, short-term, fixed-income securities are less affected by interest-rate movements than long-term, fixed-income securities.
A good strategy to limit interest-rate risk is known as laddering. Laddering is the process of investing assets in fixed-income securities with varying maturity dates, such as every year or every other year — whatever time frame works well for you. You can spread your investments over five years, ten years —, again, any time frame that you like. With laddering, you continually have money coming due that can be re-invested at the different rates. As a result, laddering enables you to avoid investing all of your money when rates are at their lowest.
So, the next time you feel the urge to gas up and head to Foxwoods, the Borgata or the Bellagio, remember that by spending a little time on risk research (less time than trying to book air or hotel on-line) and diversifying what wealth you do have among the above risk considerations, will be the best bets and safest roll of the dice you can ever make.
For more discussion and to schedule a consultation with The 411 Advisor:
Call (212) 643-5890 or (800) 223-4565