Risk is a four-letter word. To most investors, risk translates into the chances that a particular investment will lose value over a period of time. This is called Market Risk. While Market Risk is certainly a legitimate measure of risk, it fails to recognize other forms of risk that each investor should carefully consider.
Investment professionals typically measure risk based on the volatility of returns. Investments with high volatility carry greater risk. Indeed, a common way to measure the performance of a particular investment is to analyze the ?risk-adjusted? returns by factoring in the amount of volatility generated to produce a given level of returns. Morningstar and other similar services will routinely assess the risk-adjusted returns of mutual funds by using this process.
Purchasing Power Risk
Investors, fearful of losing any principal, invest their assets in low yielding bonds or even cash. By investing in securities that preserve capital, investors might lose in the long run since the returns on these 'safe? investments will be subject to the eroding power of inflation.
Having a concentrated position in one stock exposes an investor to company-specific risk. This risk is commonly mitigated by selling part of the stock or by using derivatives such as options. Unlike market risk, company-specific risk can be diversified away.
Re-investment Rate Risk
Bond investors face re-investment rate risk when interest rates fall. An investor holding a high-quality bond issued 10 years ago having a 7% coupon will be hard-pressed to find a similar bond upon maturity. Lower interest rates affect the investor's cash flow. Investing in a ?ladder? of bonds with a variety of maturity dates often mitigates this risk. When rates decline, the existing bonds in the portfolio will pay above-average rates. When interest rates move higher, the bonds maturing in the portfolio can be reinvested at higher rates. Bond laddering is akin to dollar-cost averaging with mutual funds.
In an effort to get international exposure, investors will often add non-U.S. assets to their portfolios. While international investing does have diversification benefits, it still exposes the investor to swings in value. If the value of the U.S. dollar appreciates, then the value of a foreign currency-denominated security will decrease in value.
Compared to the major industrial economies of Asia, North America, and Europe, investments in less developed countries are often exposed to political risk. Governments can topple, creating a realm of uncertainty that impacts the stocks from these countries.
Investors are confronted with a wide variety of risk. Fortunately, there are many tools and techniques available to help minimize or even eliminate the risks associated with investing. A competent advisor can help an investor navigate around these risks based on each investor's risk profile.