Determining Your Risk Profile
All kids eventually develop a risk profile and tolerance. They may be “born” with a certain attitude towards money, but most likely parents will have a big influence over the risk style that their children develop. It is important that parents know their own risk tolerance before talking to their children about the risk and reward of investing.
Fear of losing money is the most common reason people are reluctant to start investing. But there’s more to investment risk than meets the eye.
Different Types of Risk
“Our real risk is not that the market may go down tomorrow. Our real risk is that our dollars won’t buy what we need to buy when we are older or disabled.”
– Barbara Stanny, author of Prince Charming Isn’t Coming
Fear is just a symptom of ignorance. The more you know about investment risks, the less you’ll fear them. The information provided in the following pages is meant to educate you so that you are prepared to talk to your child about these factors when you feel he is ready. Since they are core financial fundamentals, it is imperative you understand them.
- Market Risk: This is when stock or bond prices drop, and you appear to lose money on your investment. However, most losses are sustained over the short term of a year or less. As long as you don’t sell, your investment will have the chance to recover from price declines and earn you a greater profit.
- Inflation Risk: The risk that the rising costs of inflation will outpace the growth of your investment over time.
- Company Risk: This is the risk that the individual company in which you invest will fail to perform as expected.
- Credit Risk: Specific to bonds, credit risk refers to the company or government’s inability to repay principal plus interest to the bondholder.
- Maturity Risk: Also specific to bonds, this is the risk that the value of a bond may change from the time it is issued to when it matures. The longer the period to maturity, the greater the potential for price fluctuation. That is why long-term bonds generally offer a higher interest rate–to compensate for this greater risk.
- Legislative Risk: Whatever laws the government passes today may be extinct tomorrow. For example, the long-term capital gains tax rate has been changed five times in the last 20 years. Factors such as tax deduction and deferral should never be your sole reasons for selecting an investment because these perks are subject to changes in Congressional policy.
- Global Risk: There are inherent risks when investing overseas, but considering that over 50% of the world’s capital market opportunities exist outside of the U.S., a purely domestic strategy can severely limit your long-term earnings potential.
- Timing Risk: Timing risk works two ways. First, you run the risk of investing a large sum of money when share prices hit their peak. Second, there’s the risk that you’ll need to access your money to pay for retirement or college expenses during a temporary market setback–causing you to lose money on your investment.
- Longevity Risk: This is the risk that you’ll live longer than your income can support you.