Types of Risk - Part 1

July 3, 2018

Now that we have built a foundation of knowledge for the many different asset class types, we can move on to understanding types of risk. As I mentioned in my blog on diversification, the old cliché of not putting all your eggs in one basket is a great metaphor for understanding that managing risk is a natural part of all investment strategies. Why? Because if something happens to that basket (your investments), for instance a strong wind that knocks it over, all your eggs will be broken. But what could happen to the basket?

Risk Level Graphic

There are 2 main types of risk:

  1. Systematic
  2. Unsystematic

Systematic risk—sorry, you can’t avoid this type of risk. You can try to mitigate it using diversification, but it’s impossible to get away from it entirely. Following are three different types of systematic risk:

  1. Market Risk
  2. Interest Rate Risk
  3. Inflation Risk

Market Risk

This is the risk that an investment will go down in value because of bad stuff that happens to the economy, like a recession, or a terrorist attack. There are ways to break down market risk further, like volatility, but they are boring so I’m not going to talk about them.

Interest Rate Risk

Interest rate risk is mainly associated with bonds but can also apply to anything that pays interest. Here, the breakdown is between price risk and reinvestment rate risk.

Price risk works like this: Bonds and interest rates have an inverse relationship, so when interest rates rise, the price of bonds decline. This is because if I hold a bond with an interest rate of 4%, and interest rates rise, that means that I could probably go out and find a bond with a higher interest rate than 4%, so the value of my 4% bond goes down. The market doesn’t deem my 4% bond as valuable because someone can probably find a bond paying a higher interest rate. (It is important to note that if I hold the bond until maturity, I will still get my money back. It hasn’t technically lost any principal. But if I tried to sell it on the market before it was due, then the price would be subject to market interest rate risk.)

Reinvestment rate risk is similar: Since bonds and other things that pay out interest at a certain rate, in cash, I then have to reinvest into something else (unless I am keeping it in cash). So, if interest rates decrease, then I will have to put my interest money into something that pays a lower interest rate than what I currently have.

Inflation Risk

Sometimes this is referred to as “purchasing power risk.” Often people don’t consider inflation risk when they keep their money in cash. Inflation is the increase in prices over time and the fall in purchasing power of money. Let’s say that you had $100 in 2000 according to this handy-dandy little calculator:

https://www.officialdata.org/2000-dollars-in-2018?amount=100

$100 in 2000 would be the equivalent of $145.50 in 2018. This means, that in order to buy the same amount of things in 2018 that you could with $100 in 2000, you now need $45.50 dollars just to breakeven. This is an increase of 45.50%, but an average inflation rate of 2.11%. This means that if you only kept your cash in a savings account earning 0.25%, you would technically be losing money every year, since in the future, you wouldn’t be able to buy as much due to prices going up. This is why it is important to invest your retirement or long-term savings, because you need growth that you are not going to get with cash alone.

The chart below from JPMorgan shows inflation for various spending categories. Notice healthcare and education are above the 2.11% average that we described above.

Average Inflation by Spending Category

Tune in next week to hear about the types of unsystematic risk!

Any opinions are those of Jill Carr and not necessarily those of RJFS or Raymond James. The information contained in this blog does not purport to be a complete description of the securities, markets, or developments referred to in this material. There is no assurance any of the trends mentioned will continue or forecasts will occur. The information has been obtained from sources considered to be reliable, but Raymond James does not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

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