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Learning CentreThe risks that surround investments
1) Market risk The risk associated with just being in the market. A market plunge will hit the shares of even the world's best companies. You might own the nicest home in the area, but an overall slump in housing will reduce its value. What you paid for something is irrelevant; it's worth only what someone will pay when you go to sell.
The risk that your investment won't keep up with inflation. It is a major concern for those who buy GICs and other seemingly "risk-free" investments. For example, you buy a 5 year GIC that pays 8%, remembering that this income stream is fixed for 5 years. If inflation averages 5% a year between now and maturity, your "real return" is only 3%. Real return is the difference between the stated return and the inflation rate. Moreover, if that GIC is not held in an RRSP or some other tax shelter, you must pay tax on the interest each year. For example, if your marginal tax rate is 40%, that cuts your 8% GIC rate to 4.8% after tax (8 x (1.00 - 0.40)). Now subtract the 5% inflation rate and you'll see you're actually losing money - or at least purchasing power - on a risk-free GIC. The same goes for Canada Savings Bonds, though their rates are adjusted each year
This is related to inflation risk. As inflation goes up, so do interest rates on newly issued bonds and other fixed-income vehicles. As interest rates rise, the market value of previously issued instruments falls. Conversely, as interest rates fall, those values rise. That is a big concern for an investor who has to sell a bond before it matures.
This risk applies when your investment is made in foreign money. Perhaps you buy shares on the New York Stock Exchange, or purchase a mutual fund that invests outside of Canada. When converted to Canadian dollars, your return will get an extra push up or down, depending on whether the Canadian dollar has gained or lost value.
Some investments are more sensitive than others to changes in the economy. The auto industry is "cyclical." It tends to do well in good times and suffer in downturns. Utilities such as telephone companies are less sensitive.
6) Company risk When you buy shares, you buy part of a business. Even in booming industries, poorly run business' lose money over time. This is known as Company risk.
7) Credit risk This is a prime concern for the income investor. What are the chances that the issuer of your bond will suspend interest payments or fail to pay back principal at maturity? What is the risk that dividends on your shares will be cut or skipped? Rating services assess those risks.
How easily can you get at your money without undue capital loss? A bank account is highly liquid and carries no risk of capital loss, as long as you're within deposit insurance limits. However, bank accounts yield very low returns. Stocks and bonds are also highly liquid and offer higher returns, but greater capital risk. Residential real estate is liquid when the market booms, but your return can be hampered or even eliminated if you have to sell when the market is down.
Government action affects every investment, either directly, through changes in tax or zoning laws, or indirectly, through economic policy. The longer you hold your investment, the more you run the risk that politicians and bureaucrats will change the rules.
Assets categories are assigned pre-determined risk weighting factors. The asset face values are then adjusted by the risk weighting factors in order to reflect a comparable risk per dollar among all types of assets.
This is the risk that proceeds
received in the future will have to be reinvested at a lower potential
interest rates.
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