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Risk and Volatility
When most people think of risk in their investment portfolios, they think of price fluctuations in the open market (also known as volatility or market risk). However, many investors don't realize that even "safe" investments can be affected by the risk of inflation eroding purchasing power. With that in mind, you should be aware of the other types of risk you may encounter with different investments.
Inflationary risk, also known as purchasing power risk, is the decline in the purchasing power of dollars over time, so that even the "safest" investments can leave investors with substantially less purchasing power. For example, assuming an inflation rate of 4% for the next 10 years, if you have a $100 today, 10 years from now inflation will have eroded that $100 so that it is worth only $68.
Investment or credit risk is the possibility that a company backing a security will not be sufficiently profitable to remain in business.
Interest rate risk is the fluctuation in the prices of some investments, such as bonds, due to changes in prevailing interest rates. When interest rates rise, new issues of bonds come to market with higher yields than older securities, making those older bonds worth less. Hence, their prices go down. When interest rates decline, new bond issues come to market with lower yields than older securities, making those older, higher-yielding bonds worth more. Hence, their prices go up. As a result, if you have to sell your bond before maturity, it may be worth more or less than you paid for it.
When considering your own risk tolerance, you should understand that investments associated with higher risk typically offer higher reward potential over time. A key factor to successful investing is to identify how much risk you are willing to assume in exchange for potential investment gains.
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