8 types of risks in finance and stock market investing

Every investment strategy carries some type of risks. Finance risk is everywhere whether you invest in stock market, bond market, real-estate, CD/GIC or keep your money under your mattress. So, the secret to success in finance is understand the risks and learn to live with them by adjusting your financial affairs.

Now, let’s have a broader overview of each type of risks in finance and stock market investing.

Stock market risk
There is no introduction needed for the risk in stock market. Stock market risk is a part of life if you have invested in equities. However, this risk can be minimize by investing in high quality blue-chip dividend stocks for long-term, and by diversify your portfolio properly. Remember, during a bad period stock prices may go up and down but dividends can keep your portfolio afloat.

Default risk
This is a most common risk for investors. For example, you buy a company stock, the company declares bankruptcy, and you are left with little or most case nothing. Do not think this can happen for stocks only. It can happen for any type of investment such as hedge fund, trusts, preferred shares, bonds, mortgage back securities.

To minimize the risk, buy well known blue-chip companies and have a proper portfolio diversification.

Accounting loopholes risk
In the past, some companies used accounting loopholes to inflate their profits and bolster staff bonuses. Some good examples are Enron Corporation (NYSE: ENE) in U.S (2001) (see in Wikipedia) and most recent one is Sino-Forest Corporation (TSE:TRE) in Canada (2011) (see in Wikipedia). Both companies were considered as large cap blue-chip companies until the companies were accused of fraud. At the end, investors were left with nothing.

Inflation risk
Inflation is a serious financial risk and many financial people understand this, but non-financial people don’t even think about it. Let’s say you have invested $1000 in a CD/GIC with rate of 1.5% and the inflation rate is at 2%. In one year, the purchasing power of you money will be $995 even though you will be earning $15 as interest on your money.

This risk can be minimized by investing your money that can generate more return than the inflation.

Interest rate risk
Currently, we are in record low interest rate environment. It may not last longer. When the central banks decide to hike the interest rates to deal with economy and inflation risk, they rarely stop at one increase. For example, U.S Fed raised the rate 17 times, all the way from 1% to 5.25% in two years between 2004 and 2006.

In that case, mortgage rates will be moving higher, and long-term bond market and high yield dividend stocks will take a hard hit because people start to move their money to saving accounts and CDs/GICs.

Tax risk
You all know about this risk and this should be considered as a major fact when you make a financial planning. This risk can be minimized by investing your money into tax-sheltered plans such as IRAs/401K in U.S and RRSPs/TFSA in Canada.

Political risk
Changes in government, political situations around the world, war, etc may impact your investment return. Diversify your portfolio by sectors and globally to minimize the risk.

Liquidity risk
Hard to find a buyer for your product is also considered as risk. You may have great asserts, but there is no buyers when the time come to sell them. For example, you have a huge house with large back yard and swimming pool – worth more than a million dollar. So, you can call yourself a millionaire by asserts, but if you can’t sell it when you need some money, then you are in a problem.

So, please understand your own finance and investment risk tolerance, and protect your hard earn money by making smart decision.