Assessing Risk While Building a Portfolio
When dealing with investments, risk essentially refers to the chance that investments will decline in value. Obviously, this decline would result in a net loss, so risk can be considered the potential for loss. Risk takes many forms in the investing world. Every investment carries with it some degree of risk. To get an accurate picture of the risk associated with a given investment or portfolio of investments, the various forms of risk should be considered collectively. The result can be viewed with potential return in the context of a given investor's goals to determine if the investment is worthwhile.
Risk can also be assessed by tracking the volatility of a given investment.
The following list includes some of the many risk factors that should be carefully considered before investing.
- Currency risk: If money must be exchanged to make a certain investment, changes in the value of the currency relative to the American dollar will affect the total loss or gain on the investment when the money is converted back. This risk usually affects businesses, but it can also affect individual investors who make international investments.
- Inflation risk: Although all investing decisions involve risk, simply not investing is not the answer. Inflation causes money to decrease in value at some rate. So inflation risk occurs whether you invest or not. It is up to you to choose investments that outpace inflation; otherwise, invested money will gradually lose value even if the principal invested is increasing at some rate.
- Interest rate risk: As interest rates change, the value of fixed-income investments such as bonds change. This risk can be reduced by diversifying the durations of the fixed-income investments that are held at a given time.
- Market risk: The value of investments may decline over a given time period simply because of economic changes or other events that impact large portions of the market. Asset allocation and diversification can protect against market risk because different portions of the market tend to underperform at different times.
- Industry risk: Changes in the environment of a particular industry may introduce a great deal of risk and cause securities connected to that industry to decline. Diversification can help to counter this risk because industries don't usually all underperform simultaneously.
- Stock-specific risk: Events that impact a particular company can have a monumental effect on the company's stock. The potential problems that can arise at a given company can infuse a great deal of risk into a particular stock. Again, this type of risk can be combated by diversification because not all companies experience problems at the same time.
- Liquidity risk: An investment may need to be sold before its maturity in order to extract the invested funds. Unfortunately, an insufficient secondary market may prevent the liquidation or limit the funds that can be generated from it. There can also be significant fees associated with liquidating some investments before a certain time. By the same token, the need to liquidate will eliminate the possibility of earning returns that would have been expected if the investment were held as long as expected.
- Principal risk: There is always the possibility that through some set of circumstances, invested money will decrease or completely disappear. In this case, principal is lost in addition to returns and expected returns . If the invested money is essential, it will have to be replaced in some way.
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