PWL Capital August 30, 2017 Personal Wealth Starting Out Investing is Risky – A Primer on (Some) Risks Associated with Investing When it comes to your money, there are many different risks that can arise. Every individual has different attitudes towards risk and different personal and financial circumstances, and therefore each plan and portfolio should incorporate that. Today I’ll be covering some of the more prevalent risks that millennials have to deal with when investing their money. The first type of risk is market risk. This is the risk associated with investing your money in the stock market. Stock prices can fall, and companies can even go bankrupt. If you’re invested in those poor performing companies, your investments will decline in value. This is typically what people are referring to when they say risk in the context of finance, but this is only 1 of the many risks. Most commonly, this risk is measured by the volatility of the portfolio. Volatility essentially means the ups and downs of your portfolio and how large those deviations are. This measure of risk determines how much fluctuation in your account you are able to deal with. Do you prefer slow and steady growth like GIC’s (guaranteed investment certificates) that earn a small but essentially guaranteed return? Or are you comfortable seeing your portfolio increase by a few percent in one month, but decline in value the next month, expecting to be compensated with a higher return? Another way for investors to view this risk is to look at the worst historical case for that portfolio (or something equivalent). This measure of market risk tests your gut reaction. If you lived through the 2008/2009 financial crisis, how did you react with your portfolio falling potentially 40% over one year? Looking at these downside numbers helps you determine whether you would be comfortable investing in a portfolio with the potential to fall dramatically, or if you should invest more conservatively to reduce the risk of bailing on a portfolio when it’s down. Next, there are specific risks associated with bonds (or fixed income). The two main ones are credit risk and term risk. Credit risk measures the probability that the company (or government) will not be able to pay you the interest and the principal amount back. In other words, the quality of the bond. Lenders are rated on a regular basis, and the higher the rating, the more likely they will continue to pay their obligations. The lower the rating, the higher chance that they won’t be able to pay you back. Term risk comes about as you purchase bonds with longer maturities. If you’re buying a one year bond, you have a decent idea of where the company will be in one year, so you have a higher expectation of getting your money back and being paid the interest for the whole year. However, if you’re buying a 20 year bond, you have less insight as to what position the lender will be in. Let’s take GM as an example. There is a high probability that GM will still be around selling cars next year. In 20 years though, we don’t know what will happen with GM. Will GM be selling self-driving cars, or will Google or companies that don’t even exist yet drive GM out of the market? There is still risk associated with GM’s bonds, as we saw by the government bail-out in 2009, but the shorter the time horizon, the less risky those bonds are, and therefore the less return they provide. Another type of risk is the risk of not meeting your goals. If you are very risk averse (in other words, you don’t like market risk), you may be tempted to eliminate that portfolio risk and instead invest in very safe GIC’s, savings accounts, or simply cash. In my last video, I outlined how investing like this poses the risk that your portfolio won’t even keep up with inflation and you’ll have to save much more to make up the difference. For some, investing in risky assets to try and earn a higher return can also result in not meeting your goals. If you have a short-term goal, say a home down payment, a market fall could wipe out a large chunk of your down payment, just when you’re ready to purchase that dream home. This is only a very small subset of the risks associated with personal finance, but will provide some context for my future videos. As I’ll outline in my next video, investors need to come up with a plan that balances these various risks so your goals are met. I’ll also outline how diversification can help combat some of these risks in a future video. Share: Facebook Twitter LinkedIn Email