Investment Risks at a Glance

[This post is written and copyrighted by FIRE Finance (http://firefinance.blogspot.com).]

July 7, 2008: The sub-prime mortgage fiasco and its effect on our investments prompted us to reconsider our portfolio's risk tolerance capability. It also reminded us that the threat of losing our money due to some bad investment decisions on our part, is not the only risk. Admittedly it is the most important one and somewhat within our control. However, we realized there are other concerns for risk as well. Here are some of the points we considered for evaluating investment risks.

Economic Risk

During an economic downturn financial markets are most likely to take nose dive too. If that happens a portfolio's value decreases. There is a silver lining to this situation though. Young investors and those having a longer time horizon for investing should seriously consider this as a rare and excellent buying opportunity. We feel that these are the times that we should go for a shopping spree - buying good investments at cheap bargains. Of course, due diligence must be done and basic investing philosophies ought not to be ignored. However it is to be noted that a prolonged economic downturn may lead to recession and more woes. How about some tips to ride out such a recession?

Market or Volatility Risk

The market might go down due to some factors over which we have no control of. As a result our investments are devalued too. In such a scenario, those of us who are close to retirement should immediately reconsider the asset mix in our portfolios. We should re-evaluate and if necessary, redo asset allocation as per our risk tolerance, time horizon and other personal scenarios.


Credit Risk

Though it may be sad but it does happen that some entity to whom we have lent money is unable to keep their promise of returning it. Sounds too familiar these days, isn't it? Yes we are talking of bond-issuers failing to return even the principal in time let alone interest. What do we do? We should stick to high credit rated bond issuers or even better, spread the risk by investing in bond index funds. In any case, there is no alternative to having a well diversified portfolio.

Inflation Risk

Well we all know about the usual decrease of purchasing power of the dollar over time aka inflation. Now consider this nightmare: our investments lag inflation. Alas! All the due diligence of investing has gone down the drain. This is one of the worst nightmares for an investor. Here are some steps that we have taken to insulate our portfolio against inflation:

• We factored in an inflation rate of 4% while calculating the expected rate of return of our portfolio. As a result we had to take extra risk in our asset allocation to earn a higher expected rate of return.
  
• Another way of making the portfolio inflation safe is to purchase inflation protected securities. We have included VIPSX in our investments.
• Diversify the portfolio with negatively correlated investments - easier said than done. Recent market dips have shown that markets all over the world are closely linked. It is becoming increasingly difficult to find negatively correlated investment instruments.
  

Currency Risk

Last but not the least, a continuously weakening dollar can cause significant worries for many of us. We are not in favor of forex trading. However, to take care of this issue we have invested in international markets. In accordance with our investing philosophy we have purchased index mutual funds and ETFs in international emerging and developed markets.

This list of investment risks is not comprehensive. We are looking forward to hear about your experiences regarding potent risks of investment. However we hope that our evaluation of investment risks and the steps we have taken to combat them will help our fellow readers take a closer look at their portfolios and evaluate its risk tolerance capabilities.

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Image Source(s): iStockPhoto

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