It’s no secret that investing comes with a degree of risk, but did you know that there are multiple types of risk? Yes, you can lose your money in more ways than one!
Don’t panic, though. Once you’re aware of the different types of risk, you’ll be better equipped to avoid them.
- Market Risk: This is the type of risk that most people are familiar with. It’s when the asset that you buy loses value instead of gains value. For example, in early 2020, Occidental Petroleum was trading at over $42, and now they are down to about $10. That represents a 76% drop in value.
- Liquidity Risk: Liquidity risk means that you can’t cash out of your investment when you need the dough. Real estate is a notoriously illiquid asset because it’s unlikely that you’ll be able to sell a property overnight. Some stocks also present a liquidity risk. If they have low trading volume, it can be hard to find someone to buy the stock at a reasonable price.
- Interest Rate Risk: Interest rates tend to fluctuate, and if you’re holding a bond at a specific interest rate, but then interest rates rise, you’re stuck holding an under-performing investment. The best way to avoid this type of risk is to holder shorter-term bonds or bonds with varying term durations.
- Reinvestment Risk: This type of risk most often applies to bonds, and it happens when the bond’s cashflow has to be reinvested at a lower rate. There are ways to overcome this by opting for longer-term bonds with infrequent cash payouts, but then this also exposes you to interest rate risk.
- Purchasing Power Risk: Inflation erodes purchasing power, allowing you to buy less with the $20 you have in your pocket today than you could yesterday. With fixed-income investments like bonds, this risk can be problematic if you were counting on that money for the future.
- Legislative Risk: Every investment is subjective to legislative risk, which is when our government passes a law that changes the rules of investing. It could be new environmental regulation, a legal restriction, or something else that throws a wrench in your otherwise perfect investment plan.
- Political Risk: If you invest your money overseas, you could expose yourself to political risk. For example, a foreign government could choose to nationalize a company or take other action that puts your investment in peril. This scenario is more likely in emerging nations or those fraught with political turmoil.
- Tax Risk: The tax code is always changing, and if the government decides to restructure capital gains in a way that doesn’t favor your situation, your ROI (return on investment) could drop. Like legislative risk, all investments are subject to losses if the government decides to take a heavy hand.
The Bottom Line
By having a deeper understanding of what kinds of risks each investment exposes you to, you’ll be able to make better choices about investments that reflect your risk tolerance.
Further, by looking at more than just the price of the asset, you can determine if an asset that is normally “safe” all of a sudden looks risky.
For example, treasury bonds have historically been a safe haven for extra cash, but with the abysmally low interest rates, there could be a very strong purchasing power risk due to inflation.
In our last issue, we shared our favorite low-risk investments during these uncertain times. Now that you’re armed with even more data about risk, you’ll be able to apply these criteria to your next investment decision.
