Risk measures to review before you invest
- Alan Lavine and Gail Liberman
Are we finally going to see a good year in the stock market?
A lot depends on future economic growth. We have to see how the tax cuts and lower interest rates spur the economy. Stock prices reflect future expectations about the economy and corporate earnings.
Before you invest in any mutual funds, be it stocks or bonds, it is important to understand all the risks. The greater the risk, the greater the potential return. But over the past three years, investors were not rewarded for taking risks.
Unfortunately, there are quite a few types of risks to consider. Market risk is the risk that your individual stock, bond or mutual fund will decline if the stock or bond market declines.There is the risk that bad news about a single company will send its stock tumbling.
On the bond side, you face interest rate risk. Bond prices move in opposite directions to interest rates. So when rates rise, bond prices fall. There also is inflation risk. The income you get from your bonds through the years, may not keep pace with rising costs.
Credit risk is the danger that a bond issuer could go bankrupt.Lost opportunity risk means that you could lock into a bond or CD rate today only to miss out on higher-yield investments tomorrow.
You can evaluate your risk from brokerage firm reports, Value Line or Morningstar, which can provide measures to help you gauge the risk of an investment. These measures include:
Beta. This tells how volatile an investment is compared with the stock market, as measured by the S&P 500. The stock market has a beta value of 1. If an investment has a beta value lower than one, it is less risky. A beta value higher than one means the investment is riskier than the overall stock market.
Individual stock recommendations. Brokerage firm reports, Value Line, Morningstar and Standard & Poor's, for example, will provide a rating on securities based on earnings potential and financial strength. High ratings mean you are less likely to lose your shirt due to bad news about a company.
On the bond side:
Look at a bond fund's "average maturity." The shorter the maturity, the less a bond will decline in price when rates rise.
Duration tells how much your bond or bond fund's value will rise or fall with a 1 percent change in interest rates.
Credit ratings. The financially strongest bond issuers are rated A to triple A by Standard & Poor's and Moody's. Bonds rate below BBB are issued by companies that are financially weak.
Alan Lavine and Gail Liberman are husband and wife columnist and authors of The Complete Idiot's Guide To Making Money With Mutual Funds, (Alpha Books).
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