When figuring out an approach to asset management, you will need to consider your tolerance for risk. In general, investments with greater risk pay higher returns because of the possibility that investors will lose everything. Conversely, investments with lower risk will pay less in dividends since it is unlikely that investors will lose money.
Importantly, you need to understand that even low-risk investments can fail, so no investment is 100 percent safe. Often, you will need to adjust your risk tolerance over time, especially as you save for investment. Sometimes, people accept higher risk for higher returns when they first start investing and then lower the risk profile of their portfolio as they approach their retirement years.
Another important thing to understand is that there are different types of risk, and mitigation strategies need to account for all varieties present. The main types of risk include the following:
1. Inflation risk
Many investors overlook inflation risk. But if your investments do not at least keep up with the rate of inflation in a market, you will lose purchasing power. Inflation means that money is actually worth less over time. For the most part, you will need to worry about inflation risk with cash or debt investments, such as bonds, as these have the lowest returns.
However, some investment products offer protection against inflation. Stocks have a lower inflation risk since the companies behind them can increase their prices, causing share prices to rise with inflation. Meanwhile, real estate is also relatively protected against inflation risk as landlords can raise rents over time.
2. Liquidity risk
Investments are only worth as much as people are willing to pay for them at a given time. You may have difficulty selling a particular investment at a fair price, which means you will either need to hold the investment for longer or accept a lower price for it.
Liquidity risk often depends on market conditions, which drives demand for certain investments. You should also think about liquidity risk in terms of difficulty selling. For example, selling real estate is much more expensive and time intensive than putting a stock or bond on the market.
3. Market risk
When people think about risk in relation to investments, they often consider market risk first. Market risk refers to declines in the value of an investment due to economic conditions.
Experts break down market risk into three categories. The first is equity risk, which applies to stocks. Supply and demand cause the price of a particular stock to vary over time, and market value may drop, meaning that investors will not get their initial investment back in total.
Next, interest rate risk involves debt investments, such as bonds. If the interest rate increases, the market value of bonds decreases, since newly issued securities will pay higher dividends.
The third category of market risk is currency risk, which applies to foreign investments. Exchange rates dictate how much a particular stock is worth in a given country; decreases in the value of a currency can cause the market price to fall.
4. Concentration risk
Concentration risk refers to concentrating money in a single category of investment. It can refer to investing in a single type of investment, such as stocks, or in a single industry. But when market conditions change and that investment category takes a hit, the entire portfolio decreases in value. Therefore, the primary way to combat concentration risk is to diversify your portfolio.
5. Horizon risk
As people save for retirement, they often plan to hold investments in the long term. However, certain events can mean that this goal is no longer feasible. For example, you may lose your job, which could necessitate selling off some investments early to make ends meet. Unfortunately, this could also mean losing money from the investment just to get some upfront cash.
6. Credit risk
When people invest in bonds, they need to think about credit risk. Government entities and companies issue bonds to raise capital quickly with the promise of paying dividends on that money and then restoring the principal after a certain period of time. However, both government entities and companies can run into financial difficulties that make it impossible to make interest payments or repay the principal once the bond reaches maturity.
Investors can lower their credit risk by investing in low-risk, low-yield bonds. Many different organizations rate the credit-worthiness of certain bonds, with the highest rating being AAA. High-rated bonds pose the lowest credit risk as well as a lower interest rate.
7. Reinvestment risk
Another risk that comes with bond investments involves reinvestment. For example, imagine buying a bond that pays a 4 percent return. If interest rates drop during the maturity period, you may be forced to reinvest the principal at a lower rate. In the interim, you may also need to reinvest the interest payments in investments that pay lower than 4 percent.
This risk does not affect people who plan to spend the interest payments or the principal once the investment reaches maturity, but people saving for retirement often do plan to reinvest.