What is Risky to You? The Many Facets of Risk
What is Risk?
Wikipedia defines risk as to the potential for uncontrolled loss of something of value. Many also associate risk as something done with uncertainty. The latter term looks more at the dispersion of outcomes and with increased dispersion comes more risk, so you should expect higher returns. Moving forward, we need to move beyond the mathematics of dispersion and view risk more holistically.
Financial Goals and Current Situation
Ultimately, we want to avoid losing value, but this must reflect our personal investment goals and current situation, which are moving targets. Hence, as investors, we need to consider, things like time horizon, income requirements, liquidity needs, tax status, and risk tolerance over time. Categorizing our objectives and situation helps to manage risk (losing value) more prudently.
Investment Goals, Investment Types, and Investment Risks
Fundamentally, you can categorize your investment goals as capital preservation, income generation, capital growth, and speculation. Note that some people will have unique situations where they need to achieve multiple goals. For example, a person may want to reserve a portion of funds for capital preservation to maintain liquidity while using the remainder to generate capital growth. Hence, don’t just assume that risk increases as you go from capital preservation to speculation. Instead, your investment goals direct your investment selection, which identifies the type of risk exposure you are willing to take.
Below is a table that helps to link investment goals with investment types and the different risks associated with those investments. Just remember, nothing is without risk, and nothing is guaranteed. Even putting your money under a mattress exposes you to certain types of risk. The critical point is to understand your investment goals, the types of investments used to achieve those goals and the risks associated with those types of investments. Until next time.
|Investment Goal||Investment Type||Risk Type|
|Income Generation||Bank Certificates of Deposits (CDs)||Inflation (purchasing power) Risk|
|Short Term U.S. Treasury Bills (< 1 year)|
|Money Market Funds|
|Current Income||U.S. Treasury Notes (1-10 years)||Inflation (purchasing power) Risk
Interest Rate Risk
Reinvestment Risk (Forced to reinvest at lower rates)
Prepayment risk (agency/mortgage-related bonds)
|U.S. Treasury Bonds (30 years)|
|Preferred Stocks/Stock Funds|
|Dividend-Focused Stocks/Stock Funds|
|High Yield Bond Funds|
|Capital Growth||Exchange-traded Stocks and Stock Funds||Market Risk/Market Volatility
Business Risk (alleviated through diversification)
Risk of Loss on Investment
|(Typically size, sector and regionally based)|
|Speculation||High Yield Bonds||Risk of Loss on Investment
Risk of Loss Beyond Investment (Leveraged Loss)
|Derivatives (Options, Futures)|