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No Way to Escape Risk
Liquidity, Growth, and a Principal Guarantee
In the current low interest rate environment, investors are looking for ways to generate a return on their investment, without taking on too much risk. As a banker I would hear people tell me all the time that they didn't want to put their money in anything that had any type of risk. I would have to explain that in life there is no such thing as risk free.
Every investment carries some kind of risk.
When you are choosing where to invest, you have to keep in mind that there are 3 things that an investment can offer: growth, liquidity, or a principal guarantee.
You can only choose 2. Think of it like this, a savings account at your bank can give you a principal guarantee and the funds are liquid; you can walk down to the bank and pull out your money at any time. A mutual fund is pretty liquid and for the most part you'll probably see growth but there is no guarantee that the $10,000 you put in on Monday will be worth $10,000 on Friday.
Think about what sorts of investments you are choosing and what sorts of risk you feel comfortable with. Are you someone that panics if your investment is worth less on Friday than it was worth on Monday? If so you probably need to avoid putting too much of your money in a mutual fund. Do you get anxious when you see your money market is earning you $0.11 a year? Maybe you need to look at something with more growth potential just keep in mind that with each investment vehicle you are sacrificing at least one other potential benefit. Moving the money in your money market into real estate might mean that you have a much greater potential for growth but if something unexpected comes up, say the car breaks down and you need a quick $2,000, you probably won't be able to sell a strip of your lawn to pay for it.
Recognizing the types of risks is the first step in smart investing.
Growth, Liquidity, or Principal Guarantee?
What is most important to you when looking at a potential investment?
Types of Risk
Interest Rate Risk - This is the risk that a fixed-rate instrument will decline in value as a result of a rise in interest rates. This a risk you face if you are purchasing a bond or a preferred stock.
Credit Risk - This is the risk that the issuer of a bond will not be able to pay. Typically you'll see a difference in the bond's rating due to this risk. The higher the rate on a bond the more likely it is to default.
Inflation Risk - This is the risk that the value of an asset or income will be eroded as inflation shrinks the value. To understand inflation I always think of the McDonald's Big Mac. When I was younger a Big Mac only cost one dollar but now a Big Mac costs $4.80. My $5 used to buy me 5 Big Macs, but now my $5 only buys me 1 Big Mac. My $5 dollars is worth less now than my $5 when I was younger.
Liquidity Risk - This is the risk that you might not be able to sell an investment when you want to. Say you own a fancy antique that you've been told is worth a million dollars. Well you decide 'you know I could really use a million dollars' so you decide to sell only suddenly there isn't a buyer for your antique. You could still say the asset is worth a million dollars but if there isn't a buyer for what you are selling its not like you can rip off a chunk of the antique for a quick 10 grand.
Market Risk - This is the type of risk that everything in the market will be affected. Think of the crash of 2008. Even companies that had nothing to do with real estate were affected and saw their market value slip.
Political Risk - This is the type of risk associated with social changes or unfavorable government action. Say you have money invested in a cigarette company and Congress passes a law outlawing nicotine, the value of your investment would plummet.
Currency Risk - This is the risk that comes from the fluctuations in the currency market. Each day the value of a dollar in comparison to a Euro or a Yuan changes. If you are investing internationally this is an important risk to keep in mind. If the dollar is strong your foreign investments value will fall. Think of it like this, if you want to get $100 American out of your foreign investment and the dollar is strong, then you'd have to sell more of your foreign investment than if the dollar was weak.