RISK VS. REWARD
Risk is the reciprocal of reward. An investor must be offered a higher rate of return for each unit of additional risk the investor is willing to assume. Many types of risks are involved when investing money, including:
• Capital risk
• Market risk
• Nonsystematic risk
• Legislative risk
• Timing risk
• Credit risk
• Reinvestment risk
• Call risk
• Liquidity risk
Capital risk is the risk that an investor may lose all or part of the capital that has been invested. Investors who purchase securities are not assured of the return of their invested principal.
Market risk is also known as a systematic risk; it is the risk that is inherent in any investment in the markets. For example, you could own stock in the greatest company in the world and you could still lose money because the value of your stock is going down, simply because the market as a whole is going down.
Nonsystematic risk is the risk that pertains to one company or industry. For example, the problems that the tobacco industry faced a few years ago would not have affected a computer company.
Legislative risk is the risk that the government will do something that adversely affects an investment. For example, beer manufacturers probably did not fare too well when the government enacted Prohibition.
Timing risk is simply the risk that an investor will buy and sell at the wrong time and will lose money as a result.
Credit risk is the risk of default inherent in debt securities. An investor may lose all or part of an investment because the issuer has defaulted and cannot pay the interest or principal payments owed to the investor.
When interest rates decline and higher yielding bonds have been called or have matured, investors will not be able receive the same return given the same amount of risk. This is called reinvestment risk, and the investor is forced to either accept the lower rate or take more risk to obtain the same rate.
INTEREST RATE RISK
Interest rate risk is the risk that the price of bonds will fall as interest rates increase. As interest rates rise, the value of existing bonds falls. This may subject the bondholder to a loss if he or she needs to sell the bond.
Call risk is the risk that as interest rates decline higher yielding bonds and preferred stocks will be called and investors will be forced to reinvest the proceeds at a lower rate of return or at a higher rate of risk to achieve the same return. Call risk only applies to preferred stocks and bonds with a call feature.
Investors who hold long-term bonds until maturity must forgo the opportunities to invest that money in other potentially higher yielding investments.
Liquidity risk is the risk that an investor will not be able to liquidate an investment when needed or that the investor will not be able to liquidate the investment without adversely affecting its price.