Monday, October 11, 2010

Understanding Investment Risk

Today, Chuck Jaffe wrote in The Wall Street Journal about a variety of different investment risks and made the case that investors are investing at precisely the wrong times because they don't understand the risks inherent in investing. Ultimately, on average, the riskier an asset, the higher potential return that comes along with it. It's impossible to eliminate all investment risk - even if a portfolio is diversified properly - as you will still face "systematic" risk or the risk that's inherent to the entire market.

Jaffe makes an excellent point in saying that "People will say they can tolerate risk, so long as they don't experience losses. They will settle for a near-zero return in a money-market fund because it is better than posting a loss without recognizing that they are losing buying power—ultimately the same impact as a loss-every day their investments fail to beat inflation."

Yes, investment risks encompass a variety of forms but one of the most important that Jaffe highlights is purchasing-power risk. If an investor is afraid to put any money in the market, they will commonly hoard it away in a seemingly "safe" investment vehicle like a savings account, CD or simply withdraw the cash entirely. This is a bad move for a variety of reasons, but the biggest is because inflation will likely erode the long-term purchasing power of the dollars as the interest earned on any bank deposits won't keep up with the rate of inflation. 

In fact, today, 5-year CDs are only averaging 2.40% according to If inflation is 4% over the next 5 years, you wind up losing 1.60% on an investment that you deemed "safe". Worse still, depending on the policies of your bank, you probably won't be able to withdraw money from your CD without incurring a penalty and you will be locked in at the stated interest rate for the 5-year term. Thus, it's important to understand the risks you face when investing because they can take shape in a variety of different ways.

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