Every investor needs to know investing in the stock market requires a thorough understanding of the risks involved. With any investment there is a risk-return trade off based on a degree of uncertainty—the greater the risk, the greater the potential for return if that risk pays off. Although it is impossible to eliminate risk when investing, educating yourself on the risks associated with the types of investments you choose will allow you to take the necessary steps to keep that risk at acceptable levels. In this article, we identify the various types of investment risks and offer strategies to lessen that risk.
When a company files for bankruptcy, stockholders may not be fully compensated for the value of their shares. In light of the risk-return tradeoff, it seems fair and logical that shareholders, who took a greater risk, are second in line to bondholders, who took a lesser risk, when a bankruptcy does occur.
Bondholders reduce their risk by forgoing the potential to benefit from any excess profits the company may earn in the future. For the higher safety of the bonds, the investors agree to receive at most their specified interest payments. This reduced risk, in effect, equals reduced returns.
Shareholders, however, have the full potential of profiting from any increases in a company’s stock price. Of course, the tradeoff for the possibility of high returns is the risk that the stock may lose value. If a company files Chapter 7 bankruptcy, debts are paid to bondholders first; therefore, shareholders may not be fully compensated for the value of their shares.
We suggest diligently researching all potential investments using credible resources such as Value Line for stocks and Morningstar for Mutual Funds. Investing in financially sound companies attempts to lessen the risk of bankruptcy.
Market risk is one of the biggest risk associated with investing. Stocks or other securities will gain or lose value, resulting in a gain or loss for you. The stock market fluctuates because of both natural and man-made factors. A single comment made by Federal Reserve Chairman Ben Bernanke or war in the Middle East could affect the stock market. As an investor, you must be willing to accept this unavoidable risk.
Bear in mind the purpose of investment planning is to minimize market risk through the selection of diversified investments. To further reduce this risk, consider hiring an experienced investment adviser who can establish the best diversification strategy for your individual situation. This investment strategy should attempt to manage your gains while minimizing your market risk.
Inflation is a fall in the market value or purchasing power of money, and everyone is affected by it. The rate of inflation can decrease the effective return of your portfolio. To counter its effects, we feel in order to do better than inflation, you should accept the risk of more variable asset classes such as stocks. While the value of your investments could fluctuate more in the short term, historically, stocks have consistently come back after short-term downturns. Over a typical market cycle, stocks have outperformed nearly all other traditional investments.
Interest Rate Risk
The relationship between interest rates and the price of fixed-rate securities, such as taxable and tax-free bonds, can expose your portfolio to risk. As interest rates fall, the prices of fixed-rate securities generally rise. Likewise, if interest rates rise, the prices of fixed-rate securities will generally fall. Consider balancing the risk by adjusting the terms of fixed-rate securities you hold. An investment adviser can help you optimize your portfolio’s performance while protecting against the risk of interest rates.
Henssler Financial recommends investing in fixed-income investments to cover specific needs. We typically ladder out bonds to mature each year to cover that year’s liquidity needs. Because we hold the bond to maturity, we reduce the risk of having to sell the bond at a time of rising interest rates.
At Henssler Financial we believe long-term investors with investment horizons of 10 years or more should stay invested in the stock market through high-quality stocks. We feel our philosophy of buying high-quality stocks is a time-tested and pure way to preserve long-term investment capital.
Bankruptcy risk, in our opinion, is the paramount risk when investing in the stock market. Because of this, we choose to only buy companies that are ranked “A” or better for financial Strength by Value Line, “A-” or better for Earnings and Dividend Quality by Standards & Poor’s, or “2” or better for safety by Value Line. This ensures that we only buy top-tier companies that receive the most scrutiny from rating agencies, and thus, are required to meet stringent financial metrics to maintain the highest ratings.
Henssler Financial can assist you with more information on investment risk. If you wish to speak to an investment adviser, please contact us at 770-429-9166 or [email protected].