No, not the old movie with Tom Cruise. If you haven’t seen it, it’s a classic, but still fiction. The types of risks I’m talking about are very real and directly impact your money. Most people have heard that investing can be risky. Many people even know that the level of risk can be associated with the volatility and potential return of an investment. What many people don’t know about is the different type of risks your investments are exposed to. I will briefly touch on a couple of the biggest and most overlooked.
First there is business risk. This is fairly strait forward. If you own stock in a company, those shares of stock are considered tiny pieces of ownership in that company. So when the company does well, your stock goes up because the company’s value goes up and vice versa. Business risk is when your particular business does not do well and your stock value drops. Management may be to blame, a faulty product, or a general change in customer preference. Whatever the case, if your company does not do well, neither will you. This type of risk can be one of the easiest to counter act. By owning a mutual fund, you are exposed to tens or hundreds of different companies’ stocks. So if a few of them don’t do so well, they won’t affect the mutual fund as a whole very much. It allows you to spread your risk out so one company failure won’t wipe you out.
The next type of risk is what I call sector risk. This is where only a particular part of the market or society is affected. The best example of this is when the “tech bubble” burst in 2000-2001. Most of the market was not negatively affected, but tech companies lost a lot of value or went out of business on a daily basis. There was a trickle down affect to some other parts of the stock and bond market, but the damage was tech specific. This is why good advisors advocate exposure to different parts of the market with your money. If you only owned tech during that time period, there is a good chance you got wiped out. If you only had 10% of your money in tech, then you only lost a portion of that 10%. That is why owning some large companies, small companies, bonds, real estate, and other investments is a good idea. They all have pros and cons, but if something falls apart, it normally won’t hinder all of your different holdings.
Now we are moving on to market risk. This is what we are experiencing right now. This is when the entire market goes up or down. Your individual company or mutual fund will have trouble escaping the pull of the entire market. This most often is fueled by scared people who sell off investments in a panic. Or, people, who get greedy and caught up in the moment and buy investments without understanding them or checking to see if they fit into their investment strategy. This type of risk can be further reaching than the other types and will affect a broad spectrum of investments. Regardless of the reasons behind these market moves, it is akin to throwing out the baby with the bathwater. Your investments will either lose or gain despite what you think should happen.
Another type of risk is political. This could be seen recently with the stock market reacting to the election of a new President. Also, when government makes policy changes or announcements, the markets will react to this information. Even political elections in other countries will affect our domestic markets in the US. The world is becoming a smaller place all the time. Political events no longer shape one country, but now can have far reaching effects on economies on the other side of the world.
The last risk I will cover (since I worry about the level or boredom I can render via this topic) is inflation risk. This can be looked at from the standpoint of our current economy. As the recovery takes place we may enter into a period of inflation where goods and services will go up in price. That is to say your money’s purchasing power goes down every year, as goods and services get more expensive. There will almost always be mild inflation and that is actually a sign of a healthy economy. So just remember, over time, your money will be worth less as the costs of products goes up. This is one more reason why investing can be so important. If your savings account or money market is paying a low interest rate, that money will actually lose value over time if it continues to sit there. That is not to say that you should not have adequate savings or an emergency fund. You should have money put aside, but once your savings are adequate, adding more money will become counterproductive. Over time investing in the market can help you to make a large enough return to make some money after you consider inflation and taxes.
....Until next time, I wish you happy and smart investing.
