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Pro Series: Understanding the different types of investment risk

Investing, whether it is planning for retirement, a child’s education or a rainy-day nest egg, can be fraught with difficult choices. Each person comes to the investing table with a unique set of financial goals and needs.

The difficult part is how we choose an investment strategy that can both meet those needs but also stay within our comfort levels for risk. A myriad of investment options provide different risk levels with corresponding reward potential.

Knowing what’s right for you is something you can discuss with your family and/or financial advisor.

Let’s look at some of the ways in which risk might factor into your investment decisions.

Risk/Reward tradeoff

Before we look at the risks themselves, a good place to start the conversation is by looking at how risk and reward work together. Generally speaking, the riskier an investment is, the greater the potential reward.

For example, different asset classes, over time, have performed differently based on their risk profile. Stocks have outpaced the returns achieved by bonds over a long-term period and short-term stock investments can often be volatile.

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And while different cash or secured investments, like U.S. Treasuries, have guaranteed rates of return with the confidence your full investment will be paid back, the reward is often minimal and may not keep up with the pace of inflation.

The opposite side of that coin is investing in an extremely risky venture like a start-up company or unproven concept. The potential rewards are extremely enticing but the losses can be devastating.

What are the various investment risks?

There are several types of risk investors should be aware of before creating their investing plan. They include:

Market Risk

This is a kind of ‘catchall’ type of risk. Many forces such as the political, economic or even geographical environments can affect financial markets. The cyclical nature of the economy will naturally affect both macro and micro aspects of investing and, as a result, influence individual stocks and securities.

Small and Mid-Cap Risk

Investment vehicles like mutual funds that invest in smaller or mid-cap size companies will be subject to small- and mid-cap risk. Essentially, smaller and medium size companies have their own set of issues such as fewer resources than larger companies, fewer markets to operate in, and/or a dependence on smaller numbers of products and services.

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These things have a tendency to create volatility for these companies. Earnings are not as predictable given their size, and management teams may be inexperienced and small, with less ability to adapt to changing situations.

Foreign Securities Risk

Looking at investments overseas can present its own risks. Currency fluctuations between the U.S. dollar and that of a foreign investment can weigh down the value of your investment.

Also, different political, economic and regulatory environments can add risk to investments that are not necessarily present with domestic investments.

Interest Rate Risk

Interest rates, governed by central banks around the globe, are raised and lowered depending on economic cycles. This can affect the bond market. As interest rates rise, the prices of bonds decrease and as they decline, the prices go up.

Because long-term bonds are the most sensitive to interest rate changes, investors are often provided with higher interest rates to compensate for the increase in risk.

Default or Credit Risk

This type of risk is relative to the financial strength of whoever is issuing the security. Companies or even governments issuing bonds can default depending on their financial situations, which may lead to an inability to repay the principal. U.S. Treasuries are considered safe and immune from default because the federal government backs them.

Liquidity Risk

Some investments are more liquid than others. Assets such as real estate or IRAs are not easily sold and could pose a risk should you require cash quickly.

Event Risk

An “event” is generally something unforeseen that can negatively affect a company or industry. In some cases this could mean the sale or purchase of one company by another.

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There could also be situations involving structural reorganizations or share buybacks all of which could have either positive or negative impacts on the market price of a stock.

Inflation Risk

Inflation refers to how much purchasing power you may have in a period of rising prices. From an investment perspective, inflation can erode the future real value of assets such as bonds and savings accounts.

Tax Risk

Taxes can affect nearly all investment types. The appreciation of an asset’s value or the income earned on it will usually have some form of taxation associated with it.

Some U.S. Treasury investments have tax exemptions. Of course, tax deferred accounts such as IRAs and 401(k)s have special tax advantages when planning for retirement.

Mitigating Risk

Investors need to understand that nearly every type of investment has some form of risk associated with it. It’s difficult to avoid out right. However, there are strategies to help manage or mitigate the risks. They include:

1. Diversification

2. Asset Allocation

3. Professional Management

Choosing several different types of asset classes, with various degrees of risk, allows investors to diversify their portfolios. Spreading the risk among aggressive, moderate and low risk investments can create a more balanced portfolio.

Before making individual investment choices it is wise to understand and know the asset classes you want to park your money into. Asset allocation, along with diversification, can help reduce short-term risks such as volatility, but maintain the goal of long-term financial gain.

Finally, as much as it is necessary to educate ourselves and understand investments and risk, it is equally important to be realistic about what we don’t know. That’s where professional management comes in.

Managers can help guide your investments into the right allocations and choices based on your personal financial goals. They can monitor your portfolio closely and rebalance it in times of fluctuation or as your needs change.

Still, there are risks with any investment and managers are just one way to assist by helping to mitigate them over time.

Getting Started

Putting money into any investment takes thought, preparation and careful consideration. Risks will always be a part of the process but there is help for investors with questions and concerns. Feel free to contact an agent or advisor from Foresters Financial to discuss your investment needs and goals.

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The information contained herein is not intended as a recommendation of a specific security or investment strategy. Rather, it is intended to be general and informational in nature. Speak with your Representative to discuss your specific situation and financial goals.

Neither Foresters Financial nor its affiliates provide legal, tax or estate planning services. Should you require such services, you should consult a legal, tax or estate planning professional.

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Joel Kranc

<p>Joel Kranc is director of Kranc Communications, a full-scale content and marketing solutions firm founded in 2011 serving a global financial services clientele. He is author of the best selling book Retirement Planning in 8 Easy Steps: The Brief Guide to Lifelong Financial Freedom. He can be reached at joel@kranccomm.com</p>