All investments, whether fixed income or equity, are exposed to some type of risk. The goal of investing is to balance the return earned from those investments with a level of risk an individual considers appropriate.
Fixed income investments are generally exposed to inflation, reinvestment and credit risks.
- Inflation risk comes into play because the income stream coming from the fixed income investment remains constant while inflation eats away at its purchasing power each year.
- This will cause the income stream from an investment to purchase less in the future.
- Reinvestment risk is the possibility of not being able to reinvest principal at the same rate that was previously offered.
- Credit risk is the hazard that the borrower will fail to repay the money being loaned as promised.
Typically, equity investments face greater exposure to market, liquidity and capital risks.
- Being exposed to market risk means that investments may decrease in value because of changes in the marketplace. These changes are not directly under the investor's control and do not necessarily reflect a change in an investment's degree of risk.
- An investment is considered liquid when an investor can buy or sell that investment quickly without substantially affecting the investment's price. Certain investments, such as real estate, cannot be sold quickly without affecting the price and are therefore exposed to liquidity risk.
- Capital risk is exhibited when a company is not profitable and may potentially file for bankruptcy. Clearly, this will affect the value of the company's securities.
An individual should select different investments based on his or her retirement goals and time horizon, as well as an appropriate level of risk.
For example, if more predictable income from investments is needed, increasing the fixed income portion of an investment portfolio can be a solution. Or, if an individual has a relatively long time to invest before retirement, owning stocks in light of their capital appreciation potential may be a viable alternative.