Risk is something you encounter everyday not just when investing. When most people think of investment risk they tend to think of the loss of their principal sum. But the question is: are there any no-risk investments?
While there are some investments that have less risk than others but there is no investment which is truly risk free. You cannot eliminate risk but you can manage it.
Perhaps if we take a look at the different types of risk it will make it easier to understand.
? Capital Risk is the type of risk that many of us think of and it is the risk of losing your invested money. This can relate to any type of investment from bonds to shares.
? Inflation Risk is the where an investor’s rate of return on investment doesn’t keep pace with the inflation rate. This risk particularly relates to term deposit funds which are normally considered low risk. If the inflation rate were to increase to a percentage higher than your return the real return would be negative.
? Interest Rate Risk is the drop in an investment’s interest rate and once again relates to the more conservative type of investment of term deposits at the bank. Bonds (referred to as fixed interest) also suffer interest rate risk. The prices of bonds move up and down, but not usually as much as shares (also known as stock). While bonds tend to be thought of as a conservative investment their returns can be volatile. If the interest rates go up the bond looses value and a decline in rates means the value goes up. There could be a significant decrease in the overall return of any particular bond because of interest rates. Bonds are a loan to a Corporate, Municipality or Government.
? Market Risk is where an investor sells their investment at a less than desired price and makes a loss such as when the price of shares drops. Shares are owned by you as investor and tend to be volatile.
? Liquidity Risk is the limitation on the availability of funds for a specific period of time. Some investments have penalties for early withdrawal whereas others do not allow withdrawal until a set time. If money is required in a hurry this will affect the investor.
? Default Risk is the failure of the organization where your investment is made. Even capital guaranteed investments are subject to this if the guarantor fails. At one time Sovereign Debt was thought of a ‘risk free’ however there have been defaults in history. And in recent times you only need to look at Iceland, Portugal, Ireland, Greece, and Spain. These countries have given us the acronym PIGS when international bond analysts are referring to faltering or indebted economies.
? Legislative Risk can affect any investment as it is the changes in tax laws and other regulation that may make certain investments less advantageous.
If you are looking for higher returns, you have to be willing to live with higher degree of r isk. But as you can see it’s impossible to avoid risk totally. We all know that you can potentially achieve higher returns through shares than with bonds and that bonds achieve higher potential returns rather than cash, but to get higher returns you need to take on some degree of volatility. At the end of the day there are no investments that have no-risk at all.
Lyn Bell has been in the finance industry for more than 30 years and is a Certified Financial Planner. She has helped many clients achieve their financial goals. Sign up to get Lyn’s free newsletter SoundFinance News and receive a free gift.
Please note this article does not contain specific advice and is for information/education purposes.
A disclosure statement is available free on request.