Sunday, January 10, 2010

The Six Classic Investment Risks – Can You Afford Them?

“Risk Tolerance” is a big deal. Every information gathering tool used by a financial advisor for a client interview addresses the issue of how much and what type of investment risk you can handle. It’s usualyy the advisor can cope with and find an acceptable investment approach – unless all the stock markets take a world-wide melt-down. Like they did twice in the last decade.

Then “Risk Tolerance” becomes a really big dea, although, by then, it’s a bit too late. Unless your investments have true guarantees built in to assure you that your hard-earned Nest Egg will never lose value, you had better get a better understanding of “Risk”. Let’s start here.

Defining Risk

Risk is the uncertainty tied to any investment decision that does not have guarantees. Since few of us can accurately predict the future, risk is then a factor in the decision-making process.
Here are the various forms of risk:
Market risk is the possibility that the value of an investment will either depreciate or appreciate because of fluctuations in the financial markets.
Interest-rate risk occurs when the direction of leading interest rates changes, directly affecting the value of an investment. (See those “safe” corporate or municipal bonds, that will go down in value every time interest rates go up.)
Inflation risk is the possible erosion of your purchasing power. An investment must yield a rate of return that exceeds the current rate of inflation to be considered a profitable investment.
Economic risk concerns the strength or weakness of near-term economic growth and its impact on investment return.
Political risk is the possibility that domestic or global political events may affect the stability of return on an investment.
Illiquidity risk is the possible absence of a buyer (or market) in the event that you are forced to sell. This typically affects real estate and collectibles.

Risk vs. Reward

Financial Advisors like to talk about “Risk vs Reward”, as if the higher the risk, the higher the potential increase in value in good times. But can you afford to have all your Nest Egg playing in the “Risk vs Reward” Game?

It is crucial to develop an investment mix that is suited to the (1) amount of Nest Egg that you can’t allow to be part of that game , and then, (2) the level of risk you are willing to assume with the rest. The point where you stand on the risk/reward spectrum depends on variables like age, family situation, current and expected future income, tax bracket, and overall net worth.

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