CFP

Types of Investment Risk - Systematic Risks

  1. Purchasing Power Risk (systematic; cash and equivalents, bonds): is the risk that the return on an investment will be reduced in significant measures by inflation. Such risk is applicable to fixed income investment, particularly short dated ones, such as money market and stable value funds, the historically low yields of which are most vulnerable to inflation over time. [An exception would be in the early 1980s when money market investments sported double digit yields, a result of then Federal Reserve Chairman Paul Volcker's stringent anti-inflationary monetary policy]. Intermediate and longer term bonds do not escape purchasing power risk, either.
  2. Interest Rate Risk (systematic; bonds): is the risk that interest rate changes will affect securities' value. Rising interest rates force down bond prices. Stock prices are negatively affected since borrowing costs tend to rise and bonds become more attractive due to their higher yields.
  3. Exchange Rate Risk (systematic; equities, bonds): the risk of a change between the value of a dollar and the value of a foreign currency in which the investment is made. Such risk exists in international funds. As an example, a U.S. dollar based investor keeps score in dollars and will receive less of a return on his or her investment, all else being equal, if the dollar strengthens relative to the foreign currency. The foreign currency returns translate into fewer dollars. By contrast, a weak dollar benefits the dollar based investor.
  4. Reinvestment Risk (systematic; bonds): the risk that earnings from current investments will not be able to be reinvested at a yield equal or superior to the yield on those current investments. As an example, if an issuer calls a bond yielding 8% in a decreasing interest rate environment, the bondholder is faced with having to reinvest at a lower rate.




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