This is the second in a series about the basics of investing. Last month, we met Aunt Jane and George. Their investing experience helped us learn about stocks and bonds. This month, they'll illustrate the risks that stockholders and bond owners face. Next month, they'll learn how to invest without having to buy individual stocks or bonds.
To find all the posts in this series, click on "investing" under the list of categories on the right side of the screen.
~Karen
We invest because it gives us the chance to make our money grow. But we also face the risk of losing money. Different types of investments have different types of risk. What exactly are the ways that we could lose money? Let's look at Aunt Jane and George from last month's post to explain them.
To recap: Aunt Jane loaned Freddie $100,000 to help start his business, Freddie's Finest Furniture. His friend, George, also put in $100,000, but he bought part of the business instead of loaning it money. Aunt Jane received interest payments on the loan. George made money by selling his part of the company for a profit. But if the business failed, George could have lost all his money. If the company went out of business or filed bankruptcy, Aunt Jane might not get back the money that she loaned them. And if the business didn't have the cash, she might not have gotten her interest payments, either.
With Aunt Jane's loan, we can learn about the types of risk that bonds and other interest-bearing investments have, such as bank accounts and savings bonds. George's purchase of part of Freddie's Finest Furniture will help us understand the risks of investments that involve ownership, such as stocks and real estate.
Risks of ownership
Let's start with George. It's no surprise that, if the business does badly, George's share of the business is worth less than what he paid. When he sells it, he'll take a loss. But there are two causes of the business doing badly. One is business risk, meaning that it's something about that particular business or that industry that goes wrong. Maybe customers stopped coming because his suppliers were unreliable or they didn't like the styles of furniture he offered. Or, maybe the entire furniture industry is having problems because people just aren't buying furniture anymore. It's become trendy to hang onto what you have or buy used furniture. It's not just Freddie. It's affecting the whole furniture industry, but the rest of the economy is OK.
That's business risk. It has to do with something specific to the individual business or its industry.
But you also face market risk. It won't matter how good of a business plan Freddie has if the entire economy is in free fall. If people are losing jobs and the stock market drops 30%, it's likely that the value of Freddie's company will drop, too. Freddie didn't do anything wrong; he was just pulled along by the movement of the overall stock market.
Risks of "Loanership"
You face a different set of risks if you own bonds or other "loanership" investments. As we saw with Aunt Jane, if the company does so badly that it doesn't have the money to make the interest payments or pay back the amount of the debt, you lose. That's credit risk – the risk that the company doesn't have the cash flow to make the payments. It's the same thing as when you go to get a loan to buy a car. The lender is going to look at your income, your other debts, and your credit history (to see how reliable you've been on paying previous debts), and decide how likely it is that you will repay the car loan. The less likely that you'll be able to repay it, the higher the interest rate the lender will charge you. Similarly, businesses that might have a hard time repaying their debts will have to offer their bondholders a higher interest rate to compensate for the higher risk.
That's just one of the risks you face when you loan money. When the bond (or CD) matures and you get your investment back, you'll have to invest it somewhere else if you don't need the money. What if interest rates have dropped? Aunt Jane was getting 7%. What if new bonds are only paying 4% when her loan matures and Freddie gives her back the $100,000? That's reinvestment rate risk – the risk that you won't be able to get the same interest rate in the future.
What if Aunt Jane needs the money before her loan to Freddie matures? Freddie doesn't have to pay her back until the maturity date. She will have to look for someone who will buy the IOU from her. If interest rates have dropped since she loaned Freddie money, everyone will want to buy her loan because it's paying a higher interest rate. She'll be able to sell it at a profit! But if interest rates have increased, it will be hard to find a buyer. She'll have to sell the loan at a discount to what she actually loaned Freddie, and she will have a loss. That's interest rate risk.
Will Aunt Jane's $100,00 have the same purchasing power at the end of the loan as it did when she loaned Freddie the money? Before she loaned him the money, Aunt Jane was thinking about using her $100,000 to buy a cute little house that was on the market. She loaned the money to Freddie instead. Ten years later when Freddie pays her back, that same house is for sale again. But now the price is $180,000. Aunt Jane had to pay taxes on the $70,000 interest she got, so she only has about $150,000 after Freddie pays her back. She can't buy as much with it now as she could have ten years ago, because inflation and taxes have eaten away at the purchasing power of the money. As you might guess, that is called purchasing power risk. It is especially a concern when you keep your money in interest bearing investments or savings accounts for a long period of time.
You might lose, but you might win!
So how many ways are there to lose money when you invest? It probably sounds like a lot, doesn't it? But in reality, risk doesn't mean losing. It's about uncertainty. With each of these types of risk, you might make money or you could lose money. The result is uncertain. The riskier the investment, the greater the range of possibilities: you could make a killing, or lose your shirt. A safer investment - one with less risk - means that you won't make a whole lot, nor are you likely to lose very much.