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Understanding Risk: Part II

Yesterday I introduced the topic of risk, and how managing your expectations and your comfort level is a big deal when investing your money.

Today I'm bringing to the table three more types of risk. Let's have a look:

Inflation Risk

Inflation risk is the risk that inflation will rise faster than your investment and that your dollars will be worth less in the future than they are today. In an effort to manage away inflation risk, or purchasing power risk, you need to look at stocks, real estate, and investments that will, over time, beat the inflation rate. During periods of moderate or low inflation the stock market performs well. During periods of high inflation the market can fall dramatically. It’s hard to beat high inflation risk, but you can ride it out with investments that have a tendency to stay ahead of the projected inflation rate. An investment such as a CD that sits at a low rate would be your worst bet because often the CD is paying less than the inflation rate. For instance, if you put $10,000 into an investment vehicle yielding a 4 percent return and earned $400, after paying tax at 28 percent (or $112.00) you would be left with $288. Then factor in the inflation rate of 3 percent on the entire investment, or $300, and you are actually ending up with a total of $9988, or coming out at –$12.

For this reason, it’s also important to gauge appropriately when looking ahead in retirement accounts. Many people do not factor in inflation. There’s no way to know what the inflation rate will be in twenty years, but always remember to include it along with taxes (in investments that are taxed) to see if you are coming out ahead.

Liquidity Risk

Liquidity risk is technically not considered an investment risk; it is not a risk based on the investment itself but on how much you need to be liquid. It is the risk that we will need our capital at a time other than we planned for. It deals with the risk of being able to rapidly convert our assets into cash. The full definition says that liquidity risk is how quickly your assets are convertible into cash at full value. Getting back a few cents on the dollar does not make you rest assured that you are not at risk. Forced liquidations and auctions are the results of not taking liquidity risk into account.

Liquidity risk is also based on, or balanced by, your need for the money in hand. You want to have a certain amount of your portfolio easily transferable to cash in the event that you need the money for an emergency. You also do not want to find yourself with no liquid assets for day-to-day needs. Beyond that, it is to some extent a state of mind or a level of comfort. Many people will prefer to have their money in stocks knowing that they can take out what they need for an emergency and not worrying about getting 79 cents or a full 100 cents back on the dollar if it’s a matter of covering medical bills for a “real world” crisis. This takes us back to the various meanings of liquidity. Money back should I need it, versus full principal back, are two responses to different levels of risk and from different personality types.

Money market funds are the low end of liquidity risk, and actual real-estate investments along with locking money into retirement plans such as IRAs and 401(k)s are on the high end of liquidity risk. The best way to manage against the potential problem is simply to determine how much money you need in your budget for a certain time period, be it weekly or monthly, and make sure you always have that money available to you plus some reserve.

NOTE: People often comment that if their stock or bond falls they haven’t lost the money unless they sell it. Actually, for the most part this is not true. If you’ve seen your stock drop from $90 to $72, when you do a new balance sheet those $18 per share will not show up on your list of assets. In this case, and with this type of investment, you are not liquid to the full value that you invested and there is no guarantee that you will be. This is a liquidity risk, in regard to full value—but by holding onto the stock you can get back to full liquid value.

Tax Risk

Tax risk is also not considered an investment risk; like liquidity risk, it isn’t a risk to the actual investment, but more to the investor. You know ahead of time which investments are taxable and which are not. It is important to determine where you will land in the “tax bracket” game, and try to determine accordingly if some (and there aren’t many) tax-free investment vehicles are a plus for your portfolio. As more singles and couples hit the higher tax brackets in a time of higher wages and low inflation, municipal bonds and municipal bond funds have appeared more attractive to many baby boomers.

Most of the investment tax management, however, does not come from the investment itself, but rather from the vehicle in which the investments are made. IRAs, 401(k)s or 403(b)s, and variable life insurance are vehicles in which you make investments. The structure provides you tax-exemption or deferral to an extent dictated by the vehicle as well as by state tax laws. Often a tax-exempt or deferred vehicle directed at retirement also falls under the “not very liquid” heading. Nonetheless, from a portfolio-building standpoint, it is also important to address tax risk.

All types of risk need to be on the table when deciding how you are going to invest. One rule of thumb: if any one of these risk factors is causing you to lose sleep at night, it's usually best to err on the side of caution and ratchet down your investment exposure to such risk factors.

Published Aug 17 2006, 02:28 PM by moneycoach
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