With Moody’s Investment Service downgrading more than a dozen global banks to reflect declining profitability, the Euro Zone looking to be in grave financial crisis, and the U.S. Economy having a gloomy shadow in the distance, many investors are asking how to find investments that carry no risk. Some of these investors are folks that are retired and looking for current income while others are at the 20 yard line approaching the end zone of their retirement day. So where do you find an investment that carries no risk?
Unfortunately, every single type of investment carries some inherent risk. Learning how to balance out that risk or being timely with your investments on knowing what risks to take at what time can ultimately determine success or failure in your overall investment plan. When it comes to today’s main risks facing investors, here are the three big I’s with respect to investing and risk.
- Inflation Risk– Inflation risk, sometimes known as purchasing power risk is the chance that the cash flows from an investment won’t be worth as much in the future because of changes in purchasing power due to rising inflation. Since the United States Federal Reserve added tremendous liquidity to the US Commercial Banking system the past four years, many people worry that the quick rise in money supply will inevitably affect a rise in inflation. So, with all of the fears going on around the world, one would think that potentially leaving money in the bank would be risk-free. If your bank account is earning 1% guaranteed and FDIC insured you will see your account statement go up. However, you need to consider that if inflation is 4% or 5%, you are safely losing the purchasing power of your money. This is a good example on how a risk-free investment could actually carry risk.
- Interest Rate Risk– Interest rate risk is essentially the risk that a bonds (security) value will change due to a change in interest rates. Interest rates and bonds generally have a see saw or inverse type relationships. That means a bonds value can actually go down when interest rates rise and a bonds value can actually go up when interest rates go down. The longer the maturity of the bond, the more of a swing the bonds value can have when interest rates spike or decline. Think about it like if there were two kids on a see saw that weighed exactly the same amount. All of a sudden one of the kids was replaced with a much heavier kid causing the see saw to be out of balance. This is the image of what it looks like when there is an interest rate change. While a bond may be making a consistent interest/coupon payment to you every six months or every quarter, you should keep an eye on the length of maturity of your bonds in case interest rates spike up again as your bond could lose significant value especially if you don’t plan to hold to maturity. If you own a bond mutual fund or bond exchange traded fund, you may want to understand what the bond funds maturity is or as more commonly known the average maturity of the bond portfolio. Although bonds can seem safe, interest rate risk could greatly affect them.
- Investment Risk– This can mean different things to different people, but I generally think about this risk with equity investments like stocks. Typically you are looking at things like business risk, valuation risk, and force of sale risk. The risk that most people are familiar with is company or business risk. We’ve all seen a business/franchise/company that we thought was really fantastic when it first hit the market. Our enthusiasm got us to invest dollars into that company or business, but the business model couldn’t sustain itself financially. Or perhaps a new and more competitive product came out that dusted the product of the company you invested in at that time. It’s best to diversify your assets within this investment category, but far too often investors basically buy the same investment just at different places. It’s like the bank investor who thinks buying 5 CD’s at 5 different banks is a strategy for diversification.
Every investor would like the ideal situation of high growth without any risk. No matter what path you go down, you will inevitably face some type of risk within your portfolio. Having a quality financial plan to determine the overall rate of return your money needs on an after-tax basis to achieve your goals is a great starting point. Figuring out after how much money you need to save to reach your goals will be an important second piece of information. Between these two factors, you can determine what kinds of risk you want to take between your current capital base and future savings. Although there is nowhere to hide your portfolio completely from risk there is certainly a difference between riding the kiddie coaster and lightning loops (this was the first upside roller coaster I ever rode at Six Flags growing up in New Jersey). Make you balance your ride so you can complete it without falling out of your seat!
Ted Jenkin, CFP®, AAMS®, AWMA®, CRPC®, CMFC®, CRPS®
Co-CEO and Founder of oXYGen Financial, Inc – The Leaders in Gen X & Y Financial Advice and Services
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