Three Investment Risks (and How to Fight Them)
When you invest, you put your money at risk. There is little opportunity for a higher return on your investment unless risk is involved. You need to understand the risks you take and how to address all of them.
There are three types of risk. Number one is economic risk. If the whole economy goes bad and the market crashes, your investments go down, too, regardless of the companies you're invested in. That's economic risk. How do you protect yourself? To begin with, spread your investments among various countries. Also, invest in things that are not related to the stock market. Bonds, for example, tend to go up when the market goes down. They can help you diversify against economic risk.
Number two is industry or sector risk. Let me give you an example: When technology was doing very well in the late '90s and early 2000s, a lot of people were betting everything on this one sector. Bad idea. As you may remember, the technology sector dropped by 90 percent, even though the rest of the economy wasn't doing so badly. People who were invested only in technology lost 90 percent of their money. Don't make those kinds of bets. Diversify. Don't put too much of your money in one sector.
The third risk investors take is company risk, where their money is too concentrated in one company. I meet these types of risk takers all the time. They've worked at a great company for years and have accumulated a lot of stock in that one company. But there's a danger. No matter how well the company has treated its employees over the years, it could happen that one day the economy is doing fine, the industry is doing very well, but the company €" isn't. Suddenly the stock goes down and investors take a big loss. How do you avoid that? Again, you diversify.
Diversification can help you fight these three risks, but you need to realize that it may not be enough. Remember 2008? There was no place to hide. That's why you need to have an exit strategy. Understand your risks, diversify to protect yourself against those risks, but make sure to have an exit strategy in case you need to run for cover to avoid investment losses
Are Bonds Too Risky Right Now?
I've been getting a lot of questions about bonds lately. People are concerned that the debt we have will drive up inflation. They worry that interest rates are going to go up. They're afraid that bonds will get killed. Should they invest in bonds right now, or is it just too risky?
I think a properly diversified portfolio should include bonds, even now. Determine how much risk is appropriate for you, and then consider how you invest in bonds.
If you own individual bonds, you can hold them to maturity. You'll get your principal back and earn interest in the meantime. But here's the problem: Let's say that you have a bond right now that pays four percent interest, a really good deal in today's world. This bond matures in ten years. But during the next ten years, we may have inflation and interest rates could go up. The value of your bond would go down when interest rates go up, and you're stuck in that bond. You can't sell it unless you want to take a loss. You're also stuck with that four percent, which may be great today, but what happens if we have inflation and interest rates rise to 16 percent?
When you invest in mutual funds, the investment company is always buying and selling the bonds before they reach their maturity dates. You could see the value of your mutual fund shares go down as interest rates go up.
By using both types of approaches and by properly diversifying your bond portfolio, you invest in bonds that you can hold to maturity, while owning others in a mutual fund that might give you the opportunity to make money.
Bonds have done phenomenally well over the last two years, despite the fact that everybody thought that the bond market was going to collapse. Yes, I think inflation is coming and interest rates are going to go up, but again, I've been thinking that for two years now. We cannot tell the future. It may be another two or three years before bonds experience problems. By avoiding bonds right now in fear of the future, you may be missing out on returns. Instead, figure out your risk and diversify your bond portfolio to hedge against future problems.
There are three types of risk. Number one is economic risk. If the whole economy goes bad and the market crashes, your investments go down, too, regardless of the companies you're invested in. That's economic risk. How do you protect yourself? To begin with, spread your investments among various countries. Also, invest in things that are not related to the stock market. Bonds, for example, tend to go up when the market goes down. They can help you diversify against economic risk.
Number two is industry or sector risk. Let me give you an example: When technology was doing very well in the late '90s and early 2000s, a lot of people were betting everything on this one sector. Bad idea. As you may remember, the technology sector dropped by 90 percent, even though the rest of the economy wasn't doing so badly. People who were invested only in technology lost 90 percent of their money. Don't make those kinds of bets. Diversify. Don't put too much of your money in one sector.
The third risk investors take is company risk, where their money is too concentrated in one company. I meet these types of risk takers all the time. They've worked at a great company for years and have accumulated a lot of stock in that one company. But there's a danger. No matter how well the company has treated its employees over the years, it could happen that one day the economy is doing fine, the industry is doing very well, but the company €" isn't. Suddenly the stock goes down and investors take a big loss. How do you avoid that? Again, you diversify.
Diversification can help you fight these three risks, but you need to realize that it may not be enough. Remember 2008? There was no place to hide. That's why you need to have an exit strategy. Understand your risks, diversify to protect yourself against those risks, but make sure to have an exit strategy in case you need to run for cover to avoid investment losses
Are Bonds Too Risky Right Now?
I've been getting a lot of questions about bonds lately. People are concerned that the debt we have will drive up inflation. They worry that interest rates are going to go up. They're afraid that bonds will get killed. Should they invest in bonds right now, or is it just too risky?
I think a properly diversified portfolio should include bonds, even now. Determine how much risk is appropriate for you, and then consider how you invest in bonds.
If you own individual bonds, you can hold them to maturity. You'll get your principal back and earn interest in the meantime. But here's the problem: Let's say that you have a bond right now that pays four percent interest, a really good deal in today's world. This bond matures in ten years. But during the next ten years, we may have inflation and interest rates could go up. The value of your bond would go down when interest rates go up, and you're stuck in that bond. You can't sell it unless you want to take a loss. You're also stuck with that four percent, which may be great today, but what happens if we have inflation and interest rates rise to 16 percent?
When you invest in mutual funds, the investment company is always buying and selling the bonds before they reach their maturity dates. You could see the value of your mutual fund shares go down as interest rates go up.
By using both types of approaches and by properly diversifying your bond portfolio, you invest in bonds that you can hold to maturity, while owning others in a mutual fund that might give you the opportunity to make money.
Bonds have done phenomenally well over the last two years, despite the fact that everybody thought that the bond market was going to collapse. Yes, I think inflation is coming and interest rates are going to go up, but again, I've been thinking that for two years now. We cannot tell the future. It may be another two or three years before bonds experience problems. By avoiding bonds right now in fear of the future, you may be missing out on returns. Instead, figure out your risk and diversify your bond portfolio to hedge against future problems.
Source...