Today we’re talking all about risk. Now we know that investing in the stock market, historically, has been a good way to build your wealth over time. But, as you’ve probably heard before, there is a cost of admission to play this game. That cost is a risk. Listen very closely: your account value WILL go down sometimes. That’s part of the process, as strange as that may sound. Think about it like this: if your account value never went down, it would be like a savings account at your bank. Are you getting really great long-term returns on your bank account money? Nope! No risk, no reward. So… what are these different types of market risk? Let’s get into it.
But first, what is market risk, anyway?
Market risk is the risk of seeing your account value go down, not because of anything specific to one company or sector, or mutual fund, but because the entire stock market goes down in value. Because this risk affects the entire market, it can’t be avoided no matter how diversified your investments may be. Not fun, but part of that price of admission we talked about.
Okay, so what types of market risk are out there?
Let’s go through some of the main ones so you can get a feel for what we’re talking about.
- Interest Rate– This one is more commonly associated with bonds rather than stocks. And the bond market can be pretty complex, but here is one little tidbit to impress your friends: Bond prices have an inverse relationship to interest rates, meaning that when interest rates go up, bond prices go down. And vice versa.
- Inflation– Inflation is the cost of goods rising over time. Think about how much you spent on your first cell phone or your first car compared to what you have now. So while keeping money out of the stock market might feel safer, you might be taking on more risk than you think if you’re not earning enough to keep up with the pace of inflation.
- Currency– This is the possibility of losing money or purchasing power due to changes in exchange rates. If you’ve ever traveled abroad, you might have had to deal with the exchange rate.
- Liquidity– Liquidity is the ability to sell something when you need money. If you own shares of a huge company like Amazon or Apple and want to sell them, those stocks are traded so often that you’ll almost never have trouble finding a buyer at a fair market price. But if you are an owner of a local business and need to sell it for cash, it might take time or you may have to sell it for a low price if you need money fast. That’s liquidity risk.
- Socio-political and Geopolitical–There are socio-political issues such as war or corruption and geopolitical risk that, at a basic level, is where geography, economics, and politics intersect. More broadly, it’s about how well different countries of the world get along – or don’t – and how a certain nation’s economic or foreign policy may affect other nations.
What Can you Do to Prepare for Market Risks?
Part of the battle is recognizing that risks will always be there and most of it is out of your control. You have to know and understand that there will be tough times when your account value goes down… and sometimes by a lot. But those are not times to panic; instead, those are times to take advantage of the opportunity to buy stuff when it is on sale. Consider putting your strategy down on paper. Jot down a reminder that you know your account value will go down sometimes, but you will not panic and stick to the plan. This will give you an advantage over your peers. You will have a better chance to build wealth compared to those who make the wrong move at the wrong time.
That’s all for now. For more on investing or anything else in your financial life, check our MoneyNav. We hope to see you soon!
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