Where
does investment risk come from?
If an investment declines in value, there is usually a good
reason. Certain factors, more than any others, contribute to such declines. These factors
are essentially the same ones that can make an investment perform well. Here are some of
them:
Business Risk
- A company may fall on hard times, negatively affecting
stock prices and potentially causing bond defaults. In the worst case, the company could
go out of business, leaving the stock or bond you hold worthless.
Market Risk
- No matter how well a company is doing, its stock price
can be adversely affected by a general decline in the stock market. "Don't fight the
tape" is an old Wall Street adage. It refers to the ticker tape (long ribbons of
paper) that was used for printing out stock transactions before the electronic age made it
obsolete. What it means is, you can't go against the trend of the market.
Interest Rate Risk
- If you want to trade a bond (sell it before its maturity
date), you will find that its price will have gone down if interest rates have gone up.
This is because an older bond paying a lower rate of interest is less attractive than a
newer one that pays a higher rate. The lower-interest bond has to be discounted (reduced
in price) in order to interest buyers. Higher interest rates also tend to negatively
affect stock prices, because they increase costs for companies (such as paying for bank
loans) and thus affect their balance sheet. If interest rates go down the effect tends to
be positive.
Inflation Risk
- This is the risk that your investment may not keep pace
with inflation. If your investment is growing at less than the 3-4% average rate of
inflation, you will end up poorer in actual buying power.
Currency Risk
- Foreign holdings are affected by changes in the exchange
rate between currencies. Changes in the exchange rate may be good or bad for your
investment, but they are unpredictable. It is not only direct investments overseas that
are affected by exchange rate risk. A few years ago, a large U.S. computer manufacturer
incurred losses from currency trading that exceeded all of its operating profit.
Political Risk
- Actions taken by the U.S. government for political
reasons could put a damper on the economy and affect investments. These include raising
taxes, imposing a minimum wage or cutting spending. Overseas investments can be hit by
serious political upheavals such as revolution, war and confiscation of property in
foreign countries. Stocks of U.S. companies with investments overseas may also be
adversely affected by political events.
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