SKIP TO SITE NAVIGATION | SWITCH TO GRAPHICAL VERSION
By Jay A. Gilburne
New York, May 4, 1998 (Standard & Poor's)
Risk Means Many Things
In past articles, we've often talked about risk in terms of the risk/reward trade-off. That is the level of risk one assumes in pursuit of a particular return potential. But there are different kinds of risk. Below, we describe five varieties of risk and suggest ways you can deal with each.
Credit Risk
Most investments involve credit risk of one degree or another. In the case of bonds, it's the possibility that the issuer may not be able to meet interest or principal payments when they come due. If this bond is part of a bond fund, it can affect the fund's overall market value. Higher-quality bonds issued by companies with strong financial positions usually pose less credit risk than those issued by companies on less solid footing. (Treasury securities, issued by the U.S. Government, tend to have the lowest credit risk.) For stocks, credit risk is the possibility that the company issuing the stock may have financial problems that could cause it to cut or suspend its dividend payments. This, in turn, often causes the company's stock price to drop. Option: Consider emphasizing investments in financially sound companies and U.S. Treasury securities.
Market Risk
This risk arises from the possibility that whole markets can decline. An investor may buy the stock of a company whose earnings and financial position are good, only to have its market price drop because overall market sentiment has turned negative. The stock or bond markets as a whole can be influenced by an unexpectedly bad economic report or non-economic developments, such as the 1991 Persian Gulf War. And, of course, if the market enters an extended period of declining prices—a bear market—all investments within that market are likely to be affected. Option: Consider diversifying among a variety of asset classes, including stocks, bonds, and cash equivalents.
Business or Event Risk
A common hazard in investing is business or event risk, which simply means that unforeseen circumstances may adversely affect the value of your investment. This risk can be either company-specific or industry wide. For example, a firm's profits may be hurt by a lawsuit, a change in management, or a product failure. Or new government regulations (i.e., for drug companies) may cause the price of stocks in a particular industry to drop. In this case, the damage is confined to one industry or one company. Option: Consider investments that offer diversification across an array of industries.
Interest Rate Risk
Changing interest rates can have a major effect on fixed-income (bond or bond fund) investments. Bond prices typically fall when interest rates rise, and they increase as rates decline. Rising interest rates depress the value of existing bonds because investors can buy new bonds paying higher prevailing yields. On the other hand, if rates fall, potential buyers will be willing to pay a premium for an older, higher-yielding bond. Either scenario will affect the current value of your investment. Generally speaking, the longer the bond's maturity, the greater its sensitivity to changing interest rates. Rising interest rates can also make stocks less attractive, though any correlation between interest rate changes and stock prices is less clear. A stock's dividend yield may be less appealing, and a company may face higher borrowing costs if money is needed to develop new products or expand operations. Option: Consider a diversified bond fund holding fixed-income securities of various maturities.
Purchasing Power Risk
In nearly every year, inflation causes a dollar to purchase less than it did the year before. That's because the cost of goods and services tends to rise year to year. The uncertainty over what your dollar will be able to buy in the future is often referred to as purchasing power risk. Even when inflation is relatively low, as it has been over the past few years, its cumulative effect over the long term is significant. An inflation rate of just 4% a year will cause your purchasing power to be cut in half in about 18 years. Option: Consider selecting investments appropriate to your risk tolerance and time horizon that have provided returns that historically have outpaced the long-term rate of inflation.
Your retirement savings plan provides the means to use the Options suggested above. Stock and bond funds, by their very nature, are diversified, and fund managers invest in securities that they believe will provide good returns at a reasonable risk given the fund's objective. You can also invest in different asset classes and choose investments that can preserve your purchasing power.
Mutual Funds are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information, can be obtained by calling your Financial Advisor. Read it carefully before you invest.
May 4, 1998 11:30:51 (01158633) Copyright 2000 Standard & Poor's Investment Advisory Services LLC. The information contained in this report may not be published, broadcast, rewritten or otherwise distributed without prior written consent from Standard & Poor's.
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