INVESTMENTS - RISK
"This section
contains additional data that supplements basic information contained in
Your
Money Matters
and should be used
in conjunction with the material contained in Your
Money Matters."
Over the past several weeks, investors have become painfully aware of one much-feared investment risk - the risk of declining stock prices. But every investment carries some element of risk.Understanding the various types is essential to effective investing. Investors should understand how risk works and how it bears on the investment decision-making process. The following sections discuss the main categories of investment risk and the effects they can have on your portfolio.
The ability of the issuer of a security (e.g., a corporation or
municipality) to generate income and repay obligations can be
jeopardized by a wide variety of factors, including broad economic
ones, such as:
Rising costs
Decreased demand for their product or service
Increased competition
Recession
Issuer-specific factors like mismanagement
Investments in large, diversified corporations are generally less subject to functional risk than are investments in small companies. But, the financial health of an issuer can deteriorate or improve, sometimes rapidly
In a free-market economy, even if it is subject to some level of government regulation, the value of an investment is determined solely by how much someone is willing to pay for it. Market risk is the danger that an investment may become unattractive to some investors. No matter how healthy the underlying company or property is, if the market sours on an investment its selling price will tumble. Indeed, during a volatile period, the market price of a particular investment can change radically even as its earning power and the health of the underlying company remains stable. Market risk can genuinely hurt the investor by eroding the price at which an investment can be sold.
Fortunately, a sound investment, as any seasoned investor knows, may be subject to market risk in the short term but can reward the investor over the long run. The chief danger of market risk is that you might be forced to sell an investment at a loss to meet immediate cash needs. Short-term interest-earning securities (often called cash-equivalent investments) are the most immune to market risk of any investment vehicle. For example, the trusty U.S. Treasury Bill (T-bill) is nearly entirely free from market risk, but investors pay a price in the form of a comparatively low yield (i.e., rate of interest paid on the investment).
Capital-value risk is associated with long-term bonds (often called
fixed-income investments), although its repercussions can also affect
the values of other investments.
(a) As interest rates rise, a long-term fixed-income investment
declines in value, so the investor is left with the choice of
settling for a lower-than-prevailing interest rate or selling the
fixed-income investment before maturity, probably at a loss.
(b) If interest rates decline, fixed-income investors enjoy a rise in
the value of their investments.
Short-term interest-earning investments carry the risk that the
income from a particular investment will decline, usually as a result
of a decline in prevailing interest rates. This risk is abundantly
evident to anyone who invested heavily in cash equivalents during the
early 1990s:
(a) Declining interest rates wrought havoc on the income received
from such investments as money market securities, T-bills, and
rolled-over certificates of deposit (CDs).
(b) On the other hand, investors in fixed-income securities fared
quite well during the same period, as the capital value of these
securities rose.
Inflation has been and continues to be an omnipresent feature of the postwar world economy. Currently, inflation has receded dramatically from the double-digit levels of the 1970s, but it still remains an important factor in the economic and investment landscape. Price-level risk is the danger that the purchasing power of an investment with a fixed face value will decline in value over time, as a result of inflation. This is often referred to as the "invisible" risk of investing, but is as significant as the visible risk of declining market value.
The funds borrowed by a bond issuer, whether a municipality, a state government, or a corporation, might not be fully repaid to the creditors or bondholders. This danger is called financial risk.
Individual investors also expose themselves to financial risk when they invest on margin or otherwise borrow funds for investment purposes. If the market value of the leveraged investment rises, investors can profit handsomely; if the value falls, investors may have difficulty repaying their creditors.
Government policy decisions or influences of society as a whole can endanger an investment's value. Environmental legislation, for example, has imposed far-reaching and often costly rules on many industries. The effect of social regulatory influences is usually difficult to predict and, at the extreme, may even jeopardize all or most of the value of a security.
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