Would you be surprised to know that the cash, in your wallet, under your mattress or in a savings account at your bank is not safe? The purchasing power of your cash is subject to inflation risk. Over time the cost of goods and services go up in price. The consumer price index that measures inflation does not even include the cost of food or energy. (Where is the logic in that?)
Inflation can also be imported from trading partners due to the changes in value of your currency. If you are Canadian, your trip to Florida this winter is going to cost you more because of the drop in value of the Canadian dollar against the U.S dollar. If you are American, coming to Canada for a summer vacation just became cheaper.
Risks in Owning Bonds
- Inflation Risk: if the yield on the bond is less than the inflation rate than you will still be losing money.
- Currency Risk: foreign bonds are subject to fluctuations in currencies. Americans who bought Canadian, Euro or Japanese bonds have lost money because of the increasing value of the U.S dollar compared to other currencies.
- Interest Rate Risk: people have a hard time understanding that raising interest rates are bad for bonds. For example, a $100 U.S. ten year bond is paying 2.3% interest, if rates go up to 3% than that same bond would drop in price to $99.32! Why would an investor pay $100 for a bond that is paying 2.3% in interest when they can buy a $100 bond paying 3%?
- Credit Risk: corporations, local governments and even countries can default on paying back interest and principal. The City of Detroit and Greece are just two examples of where bond holders didn’t get their principal back but were forced to take a small percentage of their original loans.
- Liquidity Risk: most investors purchase bonds using ETFs or mutual funds, you should be aware that a mutual fund manager may be force to sell bonds at a discount due to large redemption requests. Even bond ETFs could be difficult to sell if there isn’t enough units sold to investors.
- Market Risk: excess fear can cause investors to sell their bonds at any price during a financial crises like in 2008! Risks in Owning Stocks
Stocks are considered risker than bonds because they share some of the same risks as bonds plus a few more. Here are some brief explanations:
- Inflation Risk – Companies’ costs raise but can’t increase prices due to strong competition
- Currency Risk – Foreign sales lose value because of currency fluctuations
- Interest Rates Risk – Companies borrow money to expand, higher lending costs reduces profits
- Credit Risks – Companies do go bankrupt for a number a reasons
- Liquidly Risks– Penny & small cap stocks don’t have very many shares in the market to trade
- Market Risks – Investor’s fear & greed make stocks go up and down in valuation
- Economic Risks – periods of slow growth and recessions cause stock prices to come down
- Government tax policies – increases in corporate tax, personal income taxes, payroll taxes and foreign tax policies can effect profits
- Criminal Actions & Lawsuits – bribes to get contracts, insider trading, executive fraud and class act lawsuits like GM had to face over the deaths caused by faulty car parts
- Wars, political upheaval, weather
Risk is a part of life, do you stop driving your car to work because there is the risk of getting into an accident? Of course not, you drive defensibly, obey the rules of the road and drive according to the road conditions. Unfortunately, that doesn’t prevent some idiot driver from hitting your car.
Markets are made off any kinds of investors, the smartest and most experience investors can still lose money but they do know the risks. Sometimes even idiots can make money but over the long run it is the smart and experienced ones that come out ahead.
Educate yourself, know the risks, gauge the market conditions, learn from your mistakes and don’t worry about losing money. Remember, even Warren Buffet has made some bad investments. He bought Dexter Shoes in 1993 and lost 3.5 billion dollars!!!