Achieving success in life usually requirestaking a risk. However, just because it'srequired, doesn't mean it's enjoyed—especially in the case of the stock market. Everyphysician-investor tries to evaluate the risksinvolved before deciding where to put their hard-earneddollars. But what exactly arethe risks that investors weigh beforemaking their investment decisions?The most common one is capital risk.
Capital risk is the possibility that acompany will go under or a bond willdefault, and the value will no longer bethere (ie, loss of investment). But thereare other types of risk besides that ofcapital that investors need to considerbefore investing. Some risks are moreobvious than others, but all need to playan equal role in investment decisions.
NOTABLE INVESTOR RISKS
One of the most apparent investingfactors is market risk. Investmentswith increased volatility present agreater amount of market risk. And theamount of time an investor can waituntil they need to use the funds willdetermine how much market risk aninvestor can handle.
To evaluate market risk, determine an investment'sbeta. Beta is an approximate measure ofvolatility that is often published with other indicatorsand measures of investment performance.Although not an exact measure, a beta of 1.0means that the investment tends to move up anddown in concert with the market and with othersimilar investments. A higher beta, say 1.5, meansthat in the good times, the vehicle will outperformthe market by an average of 1/2 the market'sincrease. However, a beta of 1.5 also means thatpotential losses will be more than general marketlosses when the market does drop.
Another risk to consider before investingis interest rate risk. This is anot-so-obvious risk that relates not tolosses, but to opportunity costs (ie,money you could have made but didnot). For example, say you placed yourfunds in a 7-year bond or CD, whichearns 6%. Although the bond or CDwill mature at face amount at the endof the term, if rates increase during theterm, you will not be able to takeadvantage of those higher rates.
Although you are still getting yourinterest, the loss here is the interestyou could have received if you hadbeen able to move to the higher yieldingvehicle. In addition, interest raterisk can go hand-in-hand with marketrisk, since an increase in interest rateswill cause the value of a bond todecrease. And if you have to cash-outearly, you will lose some of your capitalif the value is down when you do.
One more risk that goes along with interestrate risk is inflation risk. Other than confusingmost people, inflation represents the change inthe buying power of a dollar. If inflation is at 3%annually now, a dollar will be able to buy 3% lessa year from now. If an investment returns 10%over the course of the year, the buying power ofthat additional money will only be able to buy7% more than it would have a year ago, effectivelydecreasing the return by the amount ofinflation. The lower an investment'sreturn, the more important the inflation risk.
THE BIG INVESTOR PICTURE
The objective of investing should be toincrease the value of your holdings, which can beaffected by inflation and the opportunity costspresented by inflation risk. Timing plays an importantrole in decreasing these market risks.Simply chasing returns or interest rates, however,may place you in a position where the fundsare needed before the returns are actually made,causing you to cash-out at a loss.
So, effective investing requires the ability toevaluate all of the risks involved and how they willimpact the vehicle in which you are investing.Knowing how long you can afford to wait to realizereturns and understanding inflation risk meansthat increases in the buying power of your moneywill not be the same as your actual return. That'swhy it's so important to understand all the risksinvolved before investing. Remember, you want tomake money, not worry about losing it.
Patrick J. Flanagan is
a financial planner in
Point Pleasant, NJ. He
welcomes questions or
comments at 800-969-
0899. The author is a
affiliated with First Montauk
Any opinions expressed
herein are the author's
and do not necessarily
reflect the opinions of
First Montauk Securities,
its officers, directors,
or affiliated registered