The term “market risk” is often heard in discussions regarding investments. It simply is recognition that an investment may actually lose value because of various factors – economic, political, or other – in the financial marketplace.
Let’s take a look at a few of these risk factors that need to be considered when building a portfolio:
Inflation risk – The return on the money being invested today must keep pace with the cost of living. If the return doesn’t keep pace with inflation, the buying power in future years will be less than it is today. This is a key consideration for retirees, especially because we may well be planning for 20 or 30 or more years.
Interest rate risk – This relates to increases or decreases in prevailing interest rates and the resulting price fluctuation of an investment, particularly bonds. Most advisors will tell you that these fluctuations are very difficult to predict. As interest rates rise, the price of bonds falls; as interest rates fall, bond prices tend to rise. One runs the risk of loss of principal if interest rates are higher when a bond is sold than rates were when it was purchased.
Reinvestment risk – This is the risk that money invested at a certain rate today will be reinvested at a lower rate upon maturity because rates have fallen. This is often a consideration with investments in bonds.
Default risk – Also known as credit risk, this is simply the risk that the company or country in which you have invested will be unable to pay back the principal or expected interest.
Political risk – This refers to anything that may happen in the political arena that could affect your portfolio, such as new legislation, changes in tax laws, changes in foreign policy, etc.
Currency risk – Given today’s global economy, changes in currency exchange rates can be a real factor as it may have an impact on U.S. corporate earnings, and certainly upon foreign investments.
The strategy for addressing these wide varieties of risk lies in a diversified portfolio that reacts differently depending upon these different kinds of risks, because the markets do not normally influence all types or classes of investment assets at the same time or in the same way. Diversification cannot guarantee a profit or ensure against a potential loss, but it can help one manage the level and types of risk to be faced.