Assessing Investment Risk

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	Investment Risk Knowing Your Limits Personal Finance Advisor by Deloitte & Touche LLP *Updated July 29, 1996*

By Tom Myers
Deloitte & Touche LLP Senior Tax Manager

The stock market and individual stocks have been experiencing unprecedented volatility this year. In fact, four of the five largest one-day declines in the history of the Dow Jones Industrial Average have occurred this year. This coming on the heels numerous record highs and an impressive 38% increase in 1995.

Naturally, the market's slide has many investors concerned. Understanding investment risks can help you cope with this volatility.

Setting the Stage: An evaluation of investment risk must consider the investor's overall financial goals. Thus, the first step is to identify financial goals -- what, how much, and when -- and list them in order of importance. Once the reasons for investing are identified and prioritized, then it is time to think about the amount of investment risk the investor is comfortable assuming.

Types of Risk: Assessing risk involves knowing both the various types of investment risk and the investor's tolerance to assuming these risks. The following are brief descriptions of the most common types of risk investors face.

Investment Risk	Definition
Market Risk	The uncertainty due to changes in the general level of market prices for investments, caused by political, social, and/or economic changes.
Company Risk	The uncertainty that a particular company may fail to meet future earnings expectations, be unable to pay dividends or interest, or succumb to the competition.
Credit Risk	The risk that a company, agency, or municipality may experience difficulty in paying its debts.
Interest Rate Risk	The risk that interest rates may rise and decrease the value of an investment.
Inflationary Risk	The uncertainty that investments will not keep pace with inflation and purchasing power will be reduced.
Reinvestment Risk	The uncertainty that the investor will not be able to reinvest the earnings and/or principal at the same rate of return that the initial investment earned.
Industry Risk	The uncertainty that a particular industry's performance may impact the growth of the investment.
Currency Risk	The uncertainty that currency fluctuations may affect the value of foreign investments or profits when converting them into the investor's local currency.

Risk Tolerance: Personal feelings about investing impact all investment decisions. Ultimately, an individual investor's tolerance to risk will determine the boundaries for appropriate investments. There is no right or wrong personal risk tolerance, but investments should never cause you to loose sleep.

Risk Versus Return: Most investors prefer certainty over uncertainty. As rates of return become more uncertain, investors expect higher returns. There can be up to components to a rate of return: the risk-free rate of return (for example, U.S. Treasury bills or T-bills), the premium over the risk-free rate of return to offset inflation risk, and the premium for a particular investment over the inflation-adjusted risk-free rate of return. The tradeoff between risk and return is fundamental to all financial decisions, and consequently, to implementing an investment strategy.

Importance of Time: The length of time that investments will be held is the single most important factor in any financial plan. The following diagram illustrates the approximate returns after inflation for stocks, bonds, and T-bills during this century, and demonstrates the effect of time on historical investment returns.

Historical performance is never a guarantee of future results. Market history, however, indicates:

Volatility, or risk, of stocks decreases significantly over time.
The return on equity securities exceeds the return on fixed income investments over long periods.
Investments that are appropriate for long-term financial goals are inappropriate if the investment time frame is relatively short.

Diversification and Asset Allocation: The lack of diversification ("having all of your eggs in one basket") can be a risky proposition. Many investors use mutual funds to diversify their investments; however, having all investments in one type of mutual fund (for instance, a stock fund) still exposes investors to the risks of that asset class.

Different categories of investments typically do not all perform well at the same time. For example, stocks and bonds often react differently to the same economic or political news. By spreading investments among various types of asset classes ("asset allocation"), a portfolio is better prepared to handle the inevitable ups and downs of the markets.

Your financial and investment advisor can provide you with more information on an appropriate investment risk and asset allocation strategy and should be consulted before any action is taken.

Tom Myers is a senior tax manager at Deloitte & Touche, with 11 years experience advising entrepreneurs and closely-held businesses on tax and business matters.