Risk in stock and bond investments is all about what might cause you to lose money on those investments. There are six main types of risk, but their varying components can be interrelated. For example, a rise in inflation limits consumer buying power, so the Federal Reserve raises interest rates to curb inflation. Higher interest rates might weaken a company's ability to sell products and borrow funds inexpensively to finance its operations without losing money. Interest rate risk increases the credit risk in that company's stock and bonds.
Inflation risk is connected less to the actual returns on stock and bonds than to your experience with those returns. Inflation involves too much money in the system chasing too few products. During inflationary periods, each dollar is worth less than it was, so the price of products rises. When inflation hits, your income from investments has less buying power.
Interest Rate Risk
The prices of both stocks and bonds change when the Federal Reserve alters interest rates to curb inflation. When companies must pay more to finance their operations, their earnings decline. Because stock prices are based on earnings, their stock prices also decline. Because bond prices are a factor of the percentage of interest paid relative to the price of the bond, when interest rates rise, bond prices fall. Conversely, when interest rates decline, company earnings rise, and so do stock prices. Bond prices also rise as interest rates decline. This risk primarily affects the price you'd receive for selling your stocks and bonds.
Market risk refers to the functioning of the marketplace. Many factors affect market function; these include banking holidays, investor anticipation, equipment failures, shocks in other markets, and anything that limits the efficient functioning of the marketplace. Market risk can affect the price of your investments, but it also can affect the ease with which you can trade securities. An example of market risk was the Flash Crash in 2010, when computer trading programs caused a rapid decline and recovery of approximately 1,000 points in the Dow Jones Industrial Average.
When a company's financial strength declines, particularly if that decline is recognized by a credit rating downgrade, it normally results in a decline in the price of both its stocks and its bonds. Its stock declines because the outlook for continued good earnings growth is doubtful. Its bond price declines because investors require higher interest payments to make up for the risk of potential default.
Liquidity risk refers to the inability to buy or sell a security at the quoted market price without a delay, or without the price changing because of scarcity of supply or demand. When a company has few shares of its common stock outstanding, or if it's has been ignored by investors, it is considered a thinly traded stock. Traders often quote according to the last transaction price. But if you place an order to buy, stock might not be available, and the price must rise to attract a seller. Likewise, when you go to sell a thinly traded stock, traders are reluctant to take it into position if there are no bids for it in the marketplace. Relative to stock, bonds are illiquid because they rarely are issued in large numbers, and they are bought mostly by institutions for long-term hold. Only the U.S. Treasury issues enough bonds for them to be considered liquid from a supply standpoint. However, even older Treasury bonds tend to disappear into portfolios and become illiquid.
Event risk is often confused with market risk. But whereas market risk is system-based, event risk is external to the system. It comes from things such as terrorist attacks, war, natural disasters and political events. These events can cause market risk, such as when the New York Stock Exchange closes because of a hurricane or a terrorist attack. They can even cause credit risk if the event badly damages a company's ability to do business.
Video of the Day
- Comstock/Comstock/Getty Images