Balancing Your Return Ideals With the Realities of Risk

Step 2: Why Don't Investments Always Live Up to My Expectations?

Investment uncertainty is not knowing what is going to happen to your investment. What could cause it to perform differently than you expected? There are several major sources of uncertainty, or risk, that could produce unexpected returns. They include:

• Business and industry risk:
  The uncertainty of an investment's ability to pay investors income, principal, and any other returns due to a significant fall-off in business (either firm-related or industry-wide) or bankruptcy. A stock, for instance, may fall in value because a firm's earnings have unexpectedly dropped due to bad management calls or an industry-wide slowdown.
• Inflation risk:
  The uncertainty over future inflation rates, which results in uncertainty over the future real (after-inflation) value of your investment. An investment that barely keeps pace with inflation will not be able to grow in real terms, leaving you with only as much purchasing power in the future as you have today.
• Market risk:
  The risk that the general market or economic environment will cause the investment to lose value regardless of the particular security. A stock may drop in value simply because the overall stock market has fallen; this is referred to as stock market risk. A bond doesn't face stock market risk, but it may drop in value due to a rise in interest rates; this is referred to as interest rate risk.
• Liquidity risk:
  The risk of not being able to get out of the investment conveniently at a reasonable price. This can occur for a number of reasons. If the market is volatile, you may be forced to sell at a significant loss if you must sell immediately. Another cause can be an inactive market. For instance, it may be difficult to sell a house simply because there are no buyers.

All investments face each of these risks, but the degree of risk varies greatly. For instance, stocks face much less inflation risk than bonds. Over the last 68 years, bonds have barely kept pace with inflation, while stocks have outpaced inflation by about 7% annually. On the other hand, short-term bonds and money market investments face little liquidity risk, while stocks face a greater liquidity risk, since you may be forced to sell at an inopportune time, suffering a large loss.

Continue to Step 3 »