How to Make Sense of Investment Risk

Understanding different types of investment risk is key to financial success.

Most investors take risk as a given, but it's important to distinguish between various forms of business and market risk. Many retirees put all their assets in low-yielding investments they believe are "safe" -- which is to say investments where they're unlikely to lose principal. What they don't understand is that they are exposing themselves to other kinds of risk that are potentially more costly.

Business risk is associated with investing in a particular product, company or business sector. An example of assuming too much business risk is heavily investing in the common stock of your employer. Most experts recommend allocating no more than 10 percent of your investable assets in the company you work for.

Another illustration of business risk is the recent misfortunes of the fossil fuel industry.

For many years oil companies were very profitable because oil prices were high. Very few industry analysts anticipated the dramatic drop in oil prices that occurred in recent years, which has dried up profits and led to significant layoffs. The fact that many of these companies are well-managed and had excellent reputations did not prevent profitability from falling dramatically, with a similar effect on stock prices.

So you can see the importance of diversification across sectors.

Market risk, which is relevant to both domestic and international companies, relates to factors that that are systemic: They affect the overall economy or securities markets. These risks include:

Interest rate risk: According to FINRA, too many investors have a poor understanding of this. When interest rates increase, bonds fall in value, and vice versa. Even if you buy long-term Treasury bonds guaranteed by the U.S. government, they will fall in value when interest rates increase. Because of the unpredictable nature of interest rates, investors have to be cautious regarding the maturity dates of the bonds or bond funds in their portfolios. Anyone who expects to cash in their bonds in the short term should never be invested in long-term bonds.

Inflation risk: The general increase in prices of goods and services will reduce the value of money, thereby reducing your purchasing power if your investments earn less than the inflation rate. On an intermediate or long-term basis, you can't afford to have a significant part of your investments in short-term CDs, savings accounts and Treasury Bills paying less than 1 percent. In order to minimize inflation risk, you must have part of your portfolio in intermediate-term bond funds and/or common-stock index funds.

Currency risk: This is the risk associated with investments in companies or mutual funds with significant foreign investments. If the U.S. dollar increases in value relative to foreign currencies, the value of your investments in those countries will fall. The U.S. dollar is currently respected more than other currencies. Accordingly, investments abroad have associated risks.

Liquidity risk: This is the risk associated with the inability to buy or sell investments quickly for a fair price. For example, if you invest in stocks or bonds that have small capitalization and trade in the over-the-counter market, with large differences between the bid and ask prices, it is harder to realize profits.

In order for you to be a successful investor, you must understand associated risks. Distinguish between short-term and long-term objectives, and select your investments accordingly.

For long-term objectives, be willing to take steps to avoid inflation risk. Use a diversified portfolio, with a mix of common-stock index funds covering multiple sectors, as well as intermediate high-quality bond funds to minimize interest rate risk. - chicagotribune