Financial Risk & Asset Classes
Risk is all around us and occurs throughout our daily life. Although it is often used in different contexts, risk is defined as the possibility that a financial outcome or investment will not be as expected. If you’re unfamiliar with the different types of risk, we’re here to help. Keep reading to learn about financial risk and asset management.
Types of Financial Risk
Risk comes in many forms. But to help you in your financial decisions, let’s look at some of the specific categories of financial risk.
- Business risk: the chance that a company you invest in will fail.
- Volatility risk: the possibility of losing or making money on the fluctuation of stock markets due to events that aren’t in any one person’s control.
- Inflation risk: the likelihood that the things you buy will become more expensive over time, reducing the purchasing power of your money.
- Interest rate risk: the uncertainty of changes in the interest rate, which will have a direct effect on bond and stock prices.
- Liquidity risk: the chance you take in investing money such that you can’t easily get your hands on it if needed.
Financial Risk and Reward
All financial investments have a fundamental tradeoff between risk and return. Potentially higher returns on investment also entail a higher risk that you’ll lose your capital. You have to decide how much financial risk you’re willing to accept in exchange for the ability to make money. Let’s compare the financial risk and reward of two common types of public securities, stocks and bonds.
To buy stocks means buying a percentage (in most cases, a tiny one) of ownership in a publicly traded company. The value of the stock is determined by the success of the company you are now a partial owner of. Buying stocks of individual companies is risky, in the specific sense of business risk, because the return on your investment is heavily dependent on the success or failure of one company. Investments that track the overall stock market spread out that business risk over many companies, so in spite of the volatility risk, they’re often much more rewarding in the long run. The historical annualized rate of return of the U.S. stock market from 1925 to 2018 is 9.8 percent (see chart) in spite of the Great Depression and many other recessions.
When you buy bonds, you’re essentially lending money to a company or government; it’s the opposite of you taking out a loan from the bank. Your investment in a bond is repaid by earning a certain interest rate for a specified period, usually anywhere from three months to 30 years. Bonds tend to be secure but low-earning investments. They’re subject to inflation risk, in that a low interest rate might not even keep up with inflation over the years, and interest rate risk, in that you could miss out on greater returns if interest rates go up after you’re already locked into an investment. And for longer-term bonds, you also have liquidity risk in giving up access to that money for a long time.
Lower Your Financial Risk
Stocks can be bought and held in your FMF365/Fidelity Investments account in any of our three stock-based investment strategies or our three mutual fund–based strategies. Learn more and start investing today.