Now more than ever, there are so many risks from financial investing that it’s difficult to keep one’s eye on all of them. This article examines the top eight risks and how we can manage them to make investment decisions that will produce measureable performance results.

1. Inflation Risk

Inflation is the general rise over the years in the prices of goods and services we consume. This means that every time a person reaches into his or her wallet and takes out some money, it buys less than it used to. Because we need to buy necessities and receive important services such as electricity, gas and water, all of us lose when the inflation rate rises. We could say that inflation is “Public Enemy #1”.

Let’s say Jill owns stock in companies that pay annual dividends to her that equal 6% of the dollar amount she paid for the stock. Bill has loaned his money to other companies by buying their bonds. They also pay 6%. They’re both happy earning this rate because inflation has been averaging between 2% and 3% over the last several years. They are getting ahead because their investments are growing faster than the rate of current prices. However, just a few years later, inflation starts rising. Before they know it, the rate is 8% per year. They’re officially losing ground. As we know, every $100 they had invested at the beginning of the year earned them 6%, or $6. By keeping $100 invested for a year, it turned into $106. However, the list of grocery items which cost $100 last year now costs 8% more, or $108!

One popular way to fight back against inflation risk is to purchase the U.S. Government’s TIPS (Treasury Inflation Protected Securities), whose value increases along with the rate of inflation.

2. Economic Risk

If you drop a piece of Styrofoam in water, it’s going to float. If you drop it in a toilet bowl and flush, it’s going to get sucked down with the water. What’s this got to do with investing? Well, consider the piece of Styrofoam is a good company whose stock you own. The water in the bowl is the economy. When the economy goes down the drain, the business and stock prices of good companies often go down with it.

By the economy going down the drain, we mean that the total amount of goods and services being produced in the country is actually dropping quarter -(i.e.: 3 month period) to-quarter. It means that consumers aren’t spending like they used to, so companies are laying off employees they no longer need. This is known as a recession.

If you own stock when the economy enters into a recession and its price falls as a result, you’ve been bitten by economic risk! Keep in mind that this is a more serious risk because it involves the entire economy and the thousands of public companies that operate in it. Recessions can last a year or more, with the damage to the employment rate and consumer confidence potentially lingering for several years after they’re over.
One way to reduce economic risk is to invest in countries around the world, as not all economies are in the same condition at the same time.

3.Market Risk

If you look at a chart of the stock market, you will see many up and down moves. Some are extreme while others are mild. A market is a place where buyers and sellers get together. It may not always operate smoothly.
Savvy traders might want to sell their holdings on a Friday so they don’t have to worry about something bad happening over the upcoming three-day weekend. On that day, more sellers than buyers will mean that prices are likely to drop. If you need to sell an investment on that day, you may get less than you could have the previous day.

Note that markets have become more and more volatile. Why?

– The cost to buy and sell an investment is just plain cheap. Brokers such as Schwab, E*Trade, and TD Ameritrade charge around $10 to buy or sell as many shares of a company as you want.

– Technology makes it very easy to enter a buy or sell order from any Internet-enabled computer or cell phone. If a sell order can be entered conveniently and inexpensively, why hold on and risk your investments tanking after bad news is announced?

– Giant hedge funds buy and sell billions of dollars of investments in a short time period and are said to have the power to move the markets.

– Finally, we should consider that the average investor, having been burned by the bursting of the Internet bubble in 2001 and the housing bubble in late 2007, may be on the lookout for any sign the economy is getting worse. They may overreact to bad news, making market risk more severe than it once was. To avoid market risk, keep an adequate amount of cash on hand and never fall into a situation where you must sell your investments when they are down.

4. Company (aka Business, Business failure) Risk

There are thousands of companies whose stocks and bonds we can invest in. The business environment is extremely competitive and not all of these companies will thrive -or even survive. Prominent corporations such as Linens N’ Things and Circuit City are gone, their investors having suffered mightily.

If a company fails, who’s to say it was the company’s own fault and not something larger, like the overall economy faltering? The answer lies in seeing how its competitors are faring. If Best Buy is holding up as Circuit City goes under, the management of Circuit City can’t blame the economy!

Common problems which may lead to a company’s demise include bad management, excessive risk taking, too much debt, failure to invest in new products, and trying to branch out into areas the company has no expertise in. To reduce company risk, invest in several leading companies in an industry you like or purchase an ETF (Exchange Traded Fund) which invests in those leading companies.

5.Systemic Risk

There are times when events occur that strain “systems” to their breaking point. People making cell phone calls on September 11th couldn’t get through. Law enforcement during Hurricane Katrina was ravaged as police officers went to protect their own families.

Our financial system has its own vulnerabilities because by its very nature, it is overextended. Banks do not keep all the cash around that their accountholders have given them. If depositors demanded their money back at the same time, the whole banking system would fail. Under a different scenario, in 2008 banks became reluctant to continue loaning money to each other. This crisis of confidence would have led to a failure of the banking system had the U.S. Government not stepped in.

How broadly you define systemic risk depends on what you judge to be a “system”. Some have defined it as a certain country, industry, or even type of investment. However, this definition appears to be too limited. Consider that systemic risk is also called undiversifiable risk. This means that there’s really nothing you can do as an investor to get away from it (except for not having your money invested). Consider that as the housing crisis played out, the values of stocks, bonds, real estate, and commodities all tanked at the same time. There was no safe investment to own.

6.Longevity Risk

Imagine that you are 65 years old, have saved up $500,000 and have decided to retire. While your half-mil seems like a lot of money, if it earns 4% in a relatively safe investment, you make only $500,000 x .04, or $20,000 per year! What to do? Spend, say, $30,000 of your savings as well. That’ll give you a $50,000 lifestyle. Only problem is, the next year, you’ll have $500,000 minus $30,000, or $470,000 earning 4%. Because you are dipping into your principal (i.e.: the amount you saved) each year, you’ll eventually run out of money! In this scenario, your money may last you 15 years, or until about 80 years of age, the average life expectancy. But, what if by 80 you are in perfect health and perfectly broke? You will have been bitten by longevity risk, the risk that you have outlived your money!

To avoid longevity risk, save enough that you can live off of only what your investments earn each year. Another way is to purchase a special type of investment from an insurance company called an annuity. You pay the company each year leading up to retirement. Then company begins paying you each and every year until you pass away. How much it pays you depends on how much you paid the company.

7.Timing Risk

They say timing in life is everything! Imagine if you poured all your money in BP stock on April 19, 2010. The next day, the Deepwater Horizon rig blows up in the Gulf of Mexico. Two days later, it sinks. Two months later, the stock price has been cut in half. Dude, you’ve got bad timing!
Avoid timing risk by practicing dollar cost averaging, which is a fancy way of saying that you should build your ownership in a company’s stock by purchasing a little bit of it at regular intervals, such as once per month. Had you done so, you could have continued to buy BP stock at ever-lower prices, or decided to take your small loss when news appeared of the rig explosion and later sinking.

8.Liquidity Risk

Something you own is liquid if you can sell it quickly without having to lower the price to get it sold. Some investments are not widely held by investors. Therefore, they are not often sold back and forth among investors. An up to date market value may not be known for them and they will be difficult to sell. Imagine if you wanted to sell an investment and no one wanted to buy it. Or, a few investors would buy it only if you dropped the asking price significantly. You’d be talking liquidity risk. To avoid liquidity risk, don’t buy rare and unusual investments that you’ll have a hard time selling!

In conclusion, understanding risk is one of the most important parts of a financial education. In the investment world, however, risk is inseparable from performance and, rather than being desirable or undesirable, is simply necessary. Every investment involves some degree of risk. A solid understanding of risk in its different forms can help investors to better understand the opportunities, trade-offs and costs involved with different investment approaches.

Author Bio: Tom Barrella is founder of http://www.investeens.com and a leading teen investing educator who teaches his Investment Decision Making course to several sections of students each year and advises another 50 students as members of the Investment Club at Syosset High School on New York’s Long Island.

Category: Finances
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