Investing offers the potential for growth and wealth accumulation, but it also comes with various risks. Understanding these risks is essential for making informed investment decisions.
Let’s go over the main risks you’ll have to contend with when you’re income investing.
The Different Investing Risks
Market Risk
All investments are subject to market risk, also known as systematic risk or volatility. It’s the general risk of the overall market or a specific asset class experiencing fluctuations in value.
Factors such as economic conditions, geopolitical events, or changes in interest rates can affect market prices.
Business and Economic Risk
Investments tied to specific businesses or sectors may be exposed to business-specific risks, such as changes in management, market competition, or regulatory issues.
Additionally, economic downturns can impact companies’ financial health, affecting their ability to pay dividends or interest.
Individual Asset Risk
This refers to the risk associated with owning a particular investment.
Factors specific to a company or issuer, such as poor management, financial distress, or legal issues, can cause the value of that asset to decline.
Inflation Risk
Inflation erodes the purchasing power of money over time. Income investments with fixed returns may not keep pace with inflation, leading to a loss of real value in terms of purchasing power.
Interest rates can also be affected by inflation, which in turn affects each type of investment differently.
Interest Rate Risk
This risk applies mainly to bonds and other fixed-income investments, since they are sensitive to changes in interest rates. You’re locked into an interest rate at the time of acquisition.
When interest rates rise, the value of existing fixed-rate investments typically falls, and vice versa. The current interest rate changes the attractiveness of both new and old bonds.
This makes it crucial to consider where interest rates may be during the full term of a fixed-income security before purchasing. You typically can’t sell these early without penalties. Preferred shares don’t have this issue.
Credit Risk
Income investments with higher yields often come from issuers with lower credit ratings, such as high-yield bonds or corporate debt.
These investments carry a higher risk of default, which means the issuer may not be able to meet its interest or principal payments as scheduled.
Liquidity Risk
This risk arises when it’s challenging to buy or sell an investment without it significantly affecting its price.
Investments with low liquidity can lead to delays or higher transaction costs when attempting to execute trades. This lack of liquidity can limit an investor’s ability to access funds when needed.
Currency Risk
Currency fluctuations can impact the value of international investments denominated in foreign currencies. Changes in exchange rates can lead to gains or losses for investors holding such assets.
Political and Regulatory Risk
Changes in government policies, regulations, or political instability can affect the business environment and impact investments, especially in specific industries or countries.
Concentration Risk
This occurs when an investor holds a significant portion of their portfolio in a single asset or a small number of assets. If those assets perform poorly, the overall portfolio could suffer significant losses.
You can avoid this by creating a well diversified portfolio.
Timing Risk
This is the risk of making investment decisions based on market timing or short-term predictions. It can be challenging to get right and even hard to nail it consistently.
A good strategy to implement instead of trying to time your entry prices is to use dollar-cost averaging. You buy in increments over a period of time which averages out your price per share.
Behavioral Risk
Investor behavior can be erratic especially when people are emotionally reacting to market movements or succumbing to herd mentality. Allowing emotions to dictate your investment decisions leads to unfavorable results.
Tax Risk
Tax policies can impact the after-tax return of income investments. Changes in tax rates or regulations may affect the overall yield an investor receives.
Reinvestment Risk
As existing income-generating assets mature or pay off, investors may not be able to reinvest at the same or higher rates, leading to lower income in the future. This often happens as interest rates decline.
To Sum Things Up
Investing inherently comes with a variety of risks. While it’s impossible to eliminate all risk, there are ways to mitigate some of the negative effects.
You’ll need to go through all of the steps of the investment planning process. Things like knowing your financial goals, doing thorough research, and implement diversification strategies will all help with risk management.
