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On ground of assurance of the return, there are
two kinds of Investments - Riskless and Risky. Riskless investments are
guaranteed, but since the value of a guarantee is only as good as the
guarantor, those backed by the full faith and confidence of a large
stable government are the only ones considered "riskless." Even
in that case the risk of devaluation of the currency (inflation)
is a form of risk appropriately called "inflation risk."
Therefore no venture can be said to be by definition "risk free"
- merely very close to it where the guarantor is a stable government.
Types of risk
Depending on the nature of the investment, the type of investment
risk will vary.
A common concern with any investment is that you may lose the
money you invest - your capital. This risk is therefore often referred
to as "capital risk."
If the assets you invest in are held in another currency there is a risk
that currency movements alone may affect the value. This is referred to
as "currency risk."
Many forms of investment may not be readily salable on the open market
(e.g. commercial property) or the market has a small capacity and can
therefore may take time to sell. Assets that are easily sold are
termed liquid therefore this type of risk is termed "liquidity risk."
The risk that there may be a disruption in the internal financial
affairs of the investment, thereby causing a loss of value, is called "financial
risk." A prime example of that form of risk was experienced by the
investors in Enron, or one of the "dot-com" stocks that really never did
have a profitable financial footing. Many of the employees of Enron
experienced both liquidity and financial risk as the price decline in
the stock of that company occurred just as there was a "freeze"
on stock liquidation in their retirement plans.
Perhaps the most familiar but often least understood form of investment
risk is "market risk." In a highly liquid market like the
collective stock exchanges in the United States and across the developed
world, the price of securities is set by the forces of supply and
demand. If there is a high demand for a given issue of stock, or a given
bond, the price will rise as each purchaser is willing to pay more for
the security than the last one. The reverse of that occurs when the
sellers want to rid themselves of an issue more than the buyers want to
buy it. Each seller is willing to receive less than the last one and the
market price, or valuation, declines.
The same form of risks apply to a house, an issue of stock, a mutual
fund, or a bond. Some forms of investment risk can be insured against.
For example, the risk that an investment rental property might
burn down, or the custodian of your stock and bond investments might go
out of business. Most of the forms of risk that we concern ourselves
with, financial risk, market risk, and even inflation risk, can at least
partially be moderated by forms of diversification.
For example, a person investing $10,000.00 for one year may desire a
gain of $1,000.00, or a 10% return, providing a total investment of
$11,000 after one year. In reality, investing, as opposed to saving,
rarely provides such a neat solution. For example, the average annual
compound return of the broad American stock market over the time period
from 1926 to 2006 was just over 10% per year. During that eighty year
period though, there were more than a few times when massive declines in
market value were experienced by investors in that same stock market.
From early in the year 2000 through the fall of the year 2002 for
example, the broad measures of market valuation, such as the S&P 500
Stock Index fell over 50%. For an investor in 2006 to have seen that
average compounded 10% return in the S&P 500 Index, he or she would have
had to invest in 1994. The 10% average annual rate or return was there,
it just took twelve years of patient waiting to see it.
At least the investor in a S&P 500 Index Fund has some degree of
assurance that if he or she waits long enough a positive return is very
likely to occur. The investor who elected to invest everything in Enron
is left only with the assurance that the investment was a complete loss.
Enron, as a stock issue, was a part of the S&P 500, and its loss did
have a temporary effect on that index, but the effect was not permanent
or, in the long run, of any significance. That is the value of
diversification. Further diversification away from the large
capitalization stocks that make up the S&P 500 Index has historically
tended to further reduce market and financial risk.
A science has evolved around managing market and financial risk under
the general title of Modern portfolio theory initiated by Dr. Harry
Markowitz in 1952 with his seminal article, "Portfolio Selection."
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