Types of Risk

Credit Risk

Credit Risk is the probability that the issuer of an investment (be it a stocks or bond) will go bankrupt and be unable to fully pay its obligations to you. A lower credit rating means more credit risk.

If a rating agency downgrades a company's credit rating, then the short-term impact will likely be a sizeable drop in that company's stock price. That is volatility.

If the company can turn things around, by say firing the old CEO and hiring a new one who has a different strategy, then your long-term risk (i.e., the chance of the permanent loss of your investment)  is reduced and the initial stock price drop was a buying opportunity.

If, however, the new CEO also fails, there may be a risk that the value of your investment drops to zero, i.e., the company goes bankrupt.

Since small companies don’t have the balance sheet strength, brand, supplier relationships, etc. of big companies, small companies tend to go bankrupt easier than big companies. That is one of the main reasons to reduce risk by focusing your investments on stocks in bigger companies that can weather the inevitable storms that appear over a company's lifetime.

Inflation Risk

Inflation is the decline in the purchasing power of money due to a general rise in prices. If inflation, also known as the Consumer Price Index (CPI) is 2% per year, the value of your money will be cut in half in 36 years, (if your not sure about this, see Investment Piece #1).

It also means that you will have to make exactly twice as much money as you make today simply to maintain the same standard of living 36 year years from now.

When you stop and consider that you will live possibly 80 or 90 years, you can see that inflation protection is a major consideration of long-term investing.

From an investment perspective, the best defence against inflation is owning stocks of companies that grow their dividends faster than the rate of inflation.

Foreign Market Risk

By foreign markets, I really mean those outside the US and Canada. These markets carry more volatility and risk because they may be less regulated and have lower standards of financial reporting. Foreign investments can also be affected by social, political, or economic instability.

The volatility and risk associated with foreign markets can be managed by primarily investing in large, developed country markets such as Europe, Japan and Australia, and allocating a much smaller percentage of your investments to developing countries such as India, Brazil and China. Once again, it is better to get your foreign market exposure by sticking to larger ETF companies such as Vanguard or iShares.

Liquidity Risk

Liquidity refers to the speed and ease with which an asset can be sold and converted into cash. Certain assets, especially smaller companies, may not be easy to sell in a down market. Once again, owning large-capitalization, dividend-paying stocks helps to manage, but not eliminate, the volatility associated with liquidity.

Borrowing Risk

Some people borrow money to finance the purchase of their investments. This involves significant risk and is not recommended for people who are new to investing or don't have a steady job. If you borrow money to buy stocks, and the stock prices decline, you still have to pay back the full amount of the loan. Having said that, the interest you pay on loans you take out to invest is tax-deductible.

However, if the market has just dropped 30 to 40%, and you have a secure job, and you have more than 10 years to invest, you may consider borrowing to invest in large-capitalization, dividend-paying stocks, as the dividends you collect will likely exceed the interest you pay on the loan. Always use extreme caution when borrowing to invest.

Don't Let Risk Paralyze You

Now, I know what you are thinking: “There is a lot of stuff I have to be worried about! I have worked hard for the money I have and I really don’t want to lose it.”

But don’t let risk paralyze you into inactivity. If you don’t invest, inflation is a real risk that will destroy the value of your money over time. Not investing is not an option.

The good news is that, if you have 10, 20 or more years to invest, then two very powerful tools, asset allocation and diversification, will help to manage your risk, (i.e., a permanent drop in the value of your portfolio).