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Education
- Investment Risk |
Investment risk, in a large sense, refers
to uncertainty. Uncertainty of yield. Uncertainty of price. Uncertainty of
receiving principal upon maturity of a bond. Basically, uncertainty that
results will match expectations.
As
a rule of thumb, the more return one seeks, the more risk one must be
willing to accept. Since we all desire the highest return at any level of
risk, and correspondingly the lowest risk at any level of return, the
massive flows of capital in pursuit of such goals renders a market in which
the risk-return relationship is indeed direct and unavoidable.
Cash
Cash instruments such as treasury bills
and money market funds are the least risky asset category. Principal is
either constantly available or soon returned, allowing for minimal to no
price fluctuation. Credit risk is minimal, given the short-term nature and
normally high-standing of the issuers. There are times in which short term
interest rates actually exceed rates on long-term bonds, such as when the
Federal Reserve fights inflation by keeping short rates high. Also, any year
the stock market stagnates or drops, cash will outperform. However, in
the long run, cash instruments usually provide the lowest rate of return. In
fact, the risk of holding cash has less to do with investment risk, of
which there is little to none, and more to do with
inflation risk.
Bonds
Bonds are similar in nature to cash
instruments in that interest and principal of set amounts will be due to the investor
at set times. If an investor holds a bond
to maturity, the rate of return will ultimately be equal to the yield to
maturity at the time of purchase. However, if an investor considers trading
bonds as one might a stock, or if the market
value of an account is of concern, or if any of the bonds being considered
are not issued by the U.S. Treasury, then one needs to be aware of risks assumed.
Most important, because payments come over longer periods of time, there is
increased exposure to credit
risk - the chance that the issuer will not be able to pay the interest or
principal due. In addition, moving interest rates cause bond prices to fluctuate.
Generally, if rates rise, bond prices fall, and vice versa. The longer the
maturity, the more prices move. Further, the lower the coupon, again the
more prices move. Still, over time, bond prices will move closer and closer
to par - the face value - as they approach maturity, lending some long term stability that
often makes an excellent counterpart to stocks. Moreover, despite occasional
spells of a "negative yield curve" environment during which short-term rates
exceed long rates, bonds have historically outperformed cash instruments and
have usually more than kept pace with inflation.
Stocks
Because nothing is guaranteed, not price,
not dividends, not earnings, not even existence, stocks are considered the
riskiest of the three major asset classes. However, because they represent
ownership of property, cash flows, earnings, products, and innovations of a
(hopefully) motivated workforce, stocks have historically
provided the best path to long-term growth. Stocks even provide a better
hedge against inflation than commodities, complementing ownership of real
assets with productive use of those assets. If the primary measure of value
added beyond cost is profit, then the real measure of a stock's worth is a
discounted valuation of expected future earnings. It follows, then, that
causes for price movements of a stock are plentiful - basically anything
that can affect any line of the income statement. However, even within the
universe of stocks there are certain securities that have over time been
less volatile than others. Generally, dividend paying stocks have fluctuated
less than non-dividend paying ones. Large, well-known companies are
generally less prone to wide price swings than newcomers and small issuers.
As with the asset classes, the sub-groupings within stocks exhibit a similar
pattern that pairs higher risk with higher expected return.