Understand each investment's level of risk
San Mateo County Times
FINANCIAL WRITERS often get so caught up in explaining the pros and cons of various investment products that they forget that much of the public is out of tune because they lack a general knowledge of investing. So let's go back to a few basics today and in some upcoming columns. I want no one left behind.
The No. 1 concern of investors -- would-be, novice or veteran -- is safety. "How safe is my money in that investment?" is the most common of all questions, and well it should be. It's natural and sensible to be wary of risk.
All investments carry some measure of risk and risk comes in various forms and degrees. In general, risk can be mitigated through diversification, the spreading of one's money across a broad spectrum of investment choices so that a loss in one investment could be offset by a gain in another. Add to that another helpful tool, liquidity. That's the ability to retrieve your money from an investment without delay or extensive cost. Most investments are liquid in our stock and bond trading system.
Specifically, here's a look at risk factors in various investments:
Common stocks: In general, the riskiest of all investments, but one where the greatest return is in the offing -- with the possible exception of properly bought and managed physical real estate. But without risk, reward is harder to come by. The hazards of individual stock ownership are offset by unquestioned liquidity and by owning stocks that pay good dividend yields. (More on stock ownership in upcoming columns.)
Stock funds: Here we find management risk. You're relying on someone else's good judgment in an account that is essentially hidden in a wrapper. This risk can be mitigated by choosing funds with good long-term performance records, meaning the manager appears to have a handle on things. No guarantees here.
Corporate bonds: Mistakenly labeled as fixed-rate and safer than stocks, but credit risk can be a killer. Will the corporation stay in business long enough to make regular interest payments and return principal at maturity? There's interest-rate risk. Will interest rates rise and depress the bond's value, meaning a loss if liquidated before maturity? And there's inflation risk. Can the ongoing income stay ahead of the inflation rate? These risks can be somewhat offset by going for a short maturity, but then the interest rate would be lower. Some bonds are callable, meaning the issuer can impose redemption.
Bond funds: Less credit risk because of diversification and professional management. But interest-rate risk is a real threat. And there's no promised escape because a bond fund never matures.
Treasury notes: No credit risk, no interest-rate risk if maturity held short, but inflation risk can be a factor, particularly when interest rates are lower than the inflation rate.
Real Estate Investment Trusts: These trade on the stock market, so market risk is real. Prices move with the general market. But REITs are the best dividend-paying section of the stock market and should be bought and held for the income they produce.
Money market funds: Credit risk is not a factor and losses are rare. But money funds' yields are well below the current rate of inflation. However, liquidity is a real plus because most money funds allow check writing on balances.
Bank accounts: Pure safety because of government insurance on every account. But yields on certificates of deposit and money market deposit accounts are still losers as they linger blow the rate of inflation.
This is a scary picture, but I don't want to discourage anyone from investing. Protect yourself through education and research.
Cliff Pletschet's Personal Finance column appears Monday. Write him at P.O. Box 28147, Oakland, CA 94604; phone (510) 531-5620 or visit www.investment-educator.com
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