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business Personal FinanceWall Street 101

Introduction | What is Risk? | Why Be Risky? | Where Does Risk Come From? | Who Can Tolerate Risk? | How To Reduce Risk | When To Avoid Risk | Timing The Market

Risk

Where does investment risk come from?

If an investment declines in value, there is usually a good reason. Certain factors, more than any others, contribute to such declines. These factors are essentially the same ones that can make an investment perform well. Here are some of them:

Business Risk

- A company may fall on hard times, negatively affecting stock prices and potentially causing bond defaults. In the worst case, the company could go out of business, leaving the stock or bond you hold worthless.

Market Risk

- No matter how well a company is doing, its stock price can be adversely affected by a general decline in the stock market. "Don't fight the tape" is an old Wall Street adage. It refers to the ticker tape (long ribbons of paper) that was used for printing out stock transactions before the electronic age made it obsolete. What it means is, you can't go against the trend of the market.

Interest Rate Risk

- If you want to trade a bond (sell it before its maturity date), you will find that its price will have gone down if interest rates have gone up. This is because an older bond paying a lower rate of interest is less attractive than a newer one that pays a higher rate. The lower-interest bond has to be discounted (reduced in price) in order to interest buyers. Higher interest rates also tend to negatively affect stock prices, because they increase costs for companies (such as paying for bank loans) and thus affect their balance sheet. If interest rates go down the effect tends to be positive.

Inflation Risk

- This is the risk that your investment may not keep pace with inflation. If your investment is growing at less than the 3-4% average rate of inflation, you will end up poorer in actual buying power.

Currency Risk

- Foreign holdings are affected by changes in the exchange rate between currencies. Changes in the exchange rate may be good or bad for your investment, but they are unpredictable. It is not only direct investments overseas that are affected by exchange rate risk. A few years ago, a large U.S. computer manufacturer incurred losses from currency trading that exceeded all of its operating profit.

Political Risk

- Actions taken by the U.S. government for political reasons could put a damper on the economy and affect investments. These include raising taxes, imposing a minimum wage or cutting spending. Overseas investments can be hit by serious political upheavals such as revolution, war and confiscation of property in foreign countries. Stocks of U.S. companies with investments overseas may also be adversely affected by political events.


The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.
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