Is it the potential loss of capital on an investment? Is it the failure to beat or match the returns of an important index? Is it receiving highly volatile returns that fluctuate greatly over time? Is it all of these things?
There are several different ways of calculating investment risk. These methods can be very technical using complex mathematical formulae and terms such as beta, standard deviation and co-variance. Simply put, there are many types of risks and these risks can adversely affect your investment.
Understanding shareholder risks can help you determine whether, or to what extent, equities are an appropriate investment. Equities are volatile and they fluctuate with market changes. When the stock market declines, it tends to pull down the value of most stocks, regardless of the strength of the underlying companies. Slower economic growth can cause the price of some investments to decline. Some industries, such as auto makers and steel plants, cannot easily cut costs during a recession. As a result, the price of their shares can decline when the growth in the economy slows down. There are also company specific risks, such as major legal action against a company that can affect its share price. New technology can make a company’s product obsolete.
Although bonds are generally less volatile than equities, they also have some risks. Default risk is the risk that the Issuer may not be able to pay the principal or the interest as it becomes due. The value of a bond may also suffer if the Issuer’s credit rating declines while the bond is outstanding. Like equities, bonds values may fluctuate in line with market conditions. Bonds are subject to interest rate risk. Generally, when interest rates rise the market value of all outstanding bonds typically falls because a bond issued yesterday at 5% is worth less to a potential purchaser than a bond issued today at 6%.
Assessing risk tolerance is a major consideration of a sound investment strategy and getting professional investment advice is highly recommended.