Category: Investment

It is important for investors to understand that every investment has its own set of risks. One key to successful investing is to recognize the different types of risks that could be a threat to one’s financial well-being and to take steps to minimize their impact. What follows is an overview of the primary forms of investment risk as well as some tips on how to minimize that risk.

Market Risk

This is the risk that the prices of securities may fall due to external factors such as world events, economic changes, or investors’ expectations and outlook. Stock investors are more likely to be impacted by this form of risk than fixed-income investors.

Inflation Risk

Also known as purchasing power risk, this is the risk that is connected to the uncertainty over the future purchasing power of the income and principal of an investment. When prices rise (inflation), purchasing power typically falls. Historically, stocks have been less impacted by this type of risk since they have been able to appreciate in price at a faster rate than the rate of inflation. Typically, lower yielding cash equivalents are more likely to be affected by a rise in inflation.

Interest Rate Risk

When interest rates move up and down, bond prices change. When interest rates move up, newly issued bonds will generally pay a higher interest rate than similar, older bonds. What happens next is that the market of existing bonds falls because there is less demand for them. In other words, they lose market value. The opposite happens when interest rates fall: Older, previously issued bonds will pay higher rates of interest than newly issued bonds, making the older bonds more appealing to investors. The bottom line is that falling interest rates are generally beneficial to bond owners.

Maturity Risk

Since it is impossible to predict how the financial markets will perform in the future, long-term bonds are generally considered to be riskier investments than short-term bonds. This type of risk is known as maturity risk. Issuers of long-term bonds attempt to compensate for the additional risk by offering higher yields.

Credit Risk

Credit risk is the risk that a bond issuer will be unable to pay interest on the bonds it issued or repay principal when the bonds mature. Rating services, such as Moody’s Investor Services and Standard & Poor’s, carefully investigate the financial health of a bond issuer in order to alert investors to the risks of a particular issue. The rating services rate municipal bonds, corporate bonds, and international bonds. They do not rate Treasury bonds since the assumption is that they are solid, backed by the full faith and credit of the federal government. The rating services rate bond quality according to a system that employs letters and numbers, with AAA or aaa indicating the highest quality issues and CCC or ccc and below indicating poor quality issues that could default.

Credit ratings influence the interest rate an issuer must pay in order to sell its bonds. However, credit ratings are opinions about credit risk. Even though credit ratings are forward looking in that they assess the impact of foreseeable future events and can be useful to investors, they are not a guarantee that an investment will pay out or that an issuer will not default.

Currency Risk

Changes in currency exchange rates will have an impact on returns from overseas investments. For example, when the dollar rises in value in relation to the Euro, the return on a fund that holds a large number of stocks in European businesses is reduced when the Euros are converted to U.S. dollars. The opposite occurs when the dollar falls in value in relation to the Euro.

All investments have risks. Before buying a security, understand that the key to investing success is balancing risk. You can do this by having a well-diversified portfolio and an asset allocation strategy based on your risk tolerance and the number of years until you retire.

Diversification helps you manage risk by spreading your assets among a broad mix of different investments. When you do this, you are taking advantage of the fact that securities usually don’t move in the same direction at the same time. When some investments drop in value, others may rise or remain unchanged, offsetting to some degree those investments that lose value. Of course, diversification does not ensure a profit or protect against loss in a declining market.

Be sure to talk to your financial professional for insights on how you can balance risk in your investment portfolio.

A mutual fund’s performance — its total return — can be either positive or negative. In other words, a fund either made or lost money for a measured time period. There are three separate elements that contribute to total return: the distribution of fund income (interest and dividends received on the fund’s investments); the distribution of capital gains; and the rise or fall in the price of fund shares. A fuller understanding of these three elements can help you make more informed decisions as an investor.

Fund Income

Bond issuers, such as corporations and the U.S. government, pay interest on the money loaned to them by the investors that buy the bonds. If you buy a government bond, for example, you know how much interest the bond will pay you over the life of the bond. Bonds are also known as “fixed-income” investments because you can anticipate your earnings.

If you own shares in a bond fund rather than an individual bond, you will share in the interest earned by the bonds in the fund. However, if you own your bond fund through an employer’s retirement plan, you do not actually receive your share of the interest income in cash. Instead, your share of the interest is reinvested in the fund and is used to buy additional shares for your account.

If you own shares in a stock fund, you may receive a distribution of dividends the fund received on its various stock holdings. Your share of the dividends paid to a stock fund you own through an employer’s retirement plan is reinvested in that fund and used to buy additional shares.

Capital Gains Distributions

When fund managers sell an investment that has increased in price, the fund will have a capital gain. Funds, of course, have losers as well as winners. When a fund sells an investment for less than it paid for it, the fund suffers a loss. Most mutual funds distribute capital gains (minus capital losses) to their shareholders at the end of the year. If you own funds through a retirement account, then the capital gains distributions are reinvested in additional fund shares.

Rise or Fall in Fund Share Prices

The market prices of stocks and bonds rarely remain static — they typically rise and fall each trading day. Thus, the share price of a fund depends on the current value of the investments it holds in its portfolio, after deduction of expenses and liabilities. As an investor, it’s important to understand that until you sell your shares in a fund, any gain or loss in their value is only a gain or loss on paper.

Total Return and Fund Performance

There are several ways to measure fund performance, and total return plays a part in each method.

• Average annual total return: One way to measure the performance of a mutual fund is to look at its average annual total return for different periods of time. A comparison of a fund’s return to a benchmark will show how the fund has performed relative to an index.

• Cumulative total return: Looking at a fund’s cumulative total return shows how much a fund has earned over a specific period.

• Year-by-year returns: It can be helpful to compare a fund’s performance from one year to the next. If you notice a wide variation year to year, the fund is most likely a highly volatile one.

You should consider the fund’s investment objectives, charges, expenses, and risks carefully before you invest. The fund’s prospectus, which can be obtained from your financial representative, contains this and other information about the fund. Read the prospectus carefully before you invest or send money. Shares, when redeemed, may be worth more or less than their original cost.

Prices of fixed income securities may fluctuate due to interest rate changes. Investors may lose money if bonds are sold before maturity.

Stock investing involves a high degree of risk. Stock prices fluctuate and investors may lose money.