Recognizing and Managing Investment Risks
As an investor, you face many risks. The most obvious is financial risk. Companies go bankrupt, trading decisions go south, the best-laid investment plans go awry, and you can end up losing your money — all or some of it — regardless of whether the economy is strong or weak. What puts your finances at risk? Here are some types of risk:
- Interest rate risk: Interest rates, set by banks and influenced by the Federal Reserve, change regularly. When the Fed raises or lowers interest rates, banks raise or lower interest rates accordingly. Interest rate changes affect consumers, businesses, and, of course, investors. Whether rising or falling interest rates are good or bad depends on the type of investment.
- Market risk: No matter how modern our society and economic system, you can't escape the laws of supply and demand. When masses of people want to buy a particular stock, it becomes in demand, and its value rises. That value rises higher if the supply is limited. Conversely, if no one's interested in buying a stock, its value falls. This is the nature of market risk. The value of your stock can rise and fall on the fickle whim of market demand. For that reason, what the market does (goes up or goes down) and its mood (bullish or bearish) impact your investments.
- Inflation risk: Inflation is the growth of the money supply without a commensurate increase in the supply of goods and services. To consumers, inflation shows up in the form of higher prices for goods and services. Inflation risk frequently is also referred to as purchasing power risk because your money doesn't buy as much as it used to.
- Tax risk: Taxes don't affect your investments directly, but they do affect how much of your money you get to keep. To minimize tax risk, be aware of the tax implications and obligations associated with the different types of investments. Because the tax rules are complex, differ for different investment vehicles and scenarios, and change regularly, talk to your accountant, tax advisor, or tax attorney for guidance.
- Political and governmental risks: If investment vehicles were fish, politics and government policies (such as taxes, laws, and regulations) would be the pond. In the same way that fish die in a toxic or polluted pond, politics and government policies greatly influence the financial stability of companies and commodities, the value of currencies — you name it.
- Emotional risk: Emotions are important risk considerations because the main decision-makers are human beings. Logic and discipline are critical factors in investment success, but even the best investor can let emotions take the reins of money management and create loss. For any kind of investing, the main emotions that can sidetrack you are fear and greed.
Despite this rather lengthy list of risks, the good news is that there are steps you can take to minimize risk.