In a previous post, we wrote a bit about risk and how to think about it, including risk tolerance. Here, we write a bit more on the subject and a number of the different types of risk that investors face, including risks around:
- Liquidity (or Illiquidity)
Liquidity refers to degree to which an asset can be quickly bought or sold in the market. If you cannot readily find a buyer for an asset, it is said to be illiquid. Investors need to consider liquidity risks when purchasing assets in the first place, as unforeseen financial or market conditions may necessitate the sudden sale of an asset. If it is illiquid, then the owner of that asset may need to sell at a discount in order to find a buyer. For this reason, many private exempt securities for which there is no robust secondary market are often viewed to have a liquidity discount baked into their price.
Whether you invest in stocks or bonds, you are always investing in the promise that the company that received your capital will stay in business. When a company goes bankrupt and its assets are liquidated, the assets and/or their value are distributed to the company’s creditors first and equity shareholders last. Depending on value of the assets and where you sit in the pecking order, you may not see any return on your capital. Literally.
Stock prices fluctuate, even for healthy viable companies. Sometimes these fluctuations are based on objective analysis of a company’s financial prospects, while other times the changes appear wholly irrational. Your ability to withstand volatility will be impacted by, among other things, your risk tolerance, investment time horizon and asset allocations.
- Interest Rates
Interest rate change frequently and impact the value of securities, particularly bonds. And, while a bond held to maturity will return its face value and interest, a bond that is sold before maturity will likely be worth more or less than its face value due to the changes in interest rates that have occurred in the interim. If interest rates have risen, newly issued bonds may be more appealing to investors than previously issued bonds with a lower interest rate. In such circumstances, an older bond may be sold at a discount to make up for the higher interest rate of newly issued bonds.
Inflation is a general increase in prices and corresponding fall in the purchasing value of money The risk of inflation is particularly heightened for those investing in fixed income securities. If the purchasing power of your capital goes down, than so too does the value of any cash equivalent received as, for example, a dividend on investment.
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