Ask the Advisor: Types of Investment Risk

Question: What are the different kinds of risks associated with investing?

The primary difficulty in investing arises from the presence of risk; however most investors make the mistake of not understanding the different sources of investment risk. These sources, or risk types, include market risk, inflation risk, interest rate risk, business/default risk, liquidity risk, political risk, exchange rate risk and tax risk.

Each type of investment risk deserves a great deal of study but I will give you a basic understanding here:

^{* Source: "Fundamentals of Investments for Financial Planning," 4th ed., Woerheide & Cordell (2004)}

Market risk: This is what most people think of when the word risk is used in association with investing. Because it is essentially the risk one takes when buying shares of any investment, market risk is a general term that includes all other types of risk. About the only way to avoid market risk is to simply hide one's cash, but even here one is still subject to inflation risk.

Inflation risk: This is the risk of losing purchasing power because of the rise in the level of prices. If your investment does not provide average annualized returns above the rate of inflation, which averages around three percent historically, your purchasing power decreases (the value of money now is less than it was in the past and more than it will be in the future).

Interest rate risk: Interest rates not only affect rates for consumer credit but they also affect investment prices, especially those of bonds. As interest rates rise, for example, the prices for bonds fall, and vice-versa. The current economic environment outlook is for rising interest rates, which is why bonds have not done as well as stocks lately.

Business/Default risk: Businesses can experience financial difficulties, as we have seen in recent years. This increases the risk of default, namely on bond payments. Typically, businesses that have higher risk of default must pay higher interest rates on bonds, which is why bond yields are higher on riskier businesses (hence, the term high-yield or "junk" bond).

Liquidity risk: Most investors don't face this type of risk because the commonly traded investments are easy to buy and sell (easily converted to cash) on the open market. Thus, liquidity risk refers to the measure of ability to sell an asset quickly.

Political risk: We've recently seen this risk in action in the middle-eastern countries, such as Egypt. Investments in foreign-based companies or U.S. companies with significant revenue or assets overseas countries are subject to additional risk in those countries.

Exchange rate risk: This risk is relevant for individuals investing in foreign companies since the value of their investment in dollars can decline eve if the company does well, if the value of the dollar rises relative to the value of the currency in the country where the investment is located.

Tax risk: Most investments have some tax consequences. The extent to which an investment is exposed to changes in tax laws is its tax risk. The government can provide or eliminate tax advantages.

Perhaps the greatest risk in investing is a lack of education. Let me know if you have any more questions!

Kent Thune is a Certified Financial Planner™ and owner of an independent, "fee-only" investment management firm in Mount Pleasant, SC. Kent is also a freelance writer. To read more of his work or to find out how to contact Kent, please visit his blog at The Financial Philosopher. Have a question? Email AsktheAdvisor@savings.com.

_{Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment} ^{advice. Under no circumstances does this information represent a recommendation to buy or sell securities.}