Can You Really Afford a Guarantee--Part 2

Last time, we looked briefly at the historical returns of the stock market verses FDIC insured vehicles and clearly, the evidence suggest that when inflation is factored in, so-called "secure" investments are not so risk-free when you consider how much you will have to spend when the time comes to purchase goods or services.

Now, let’s look at what exactly “risk” is when it comes to investing.


Business risk and market risk is the risk that an individual investment or a diversified portfolio, respectively, will decline in value.  A recession usually brings to light what market risk is.  Think of Lehman Brothers when it comes to business risk.


Liquidity risk is the risk that when you need to turn your investment into cash, you won’t be able to as fast as you want and you may be stuck selling at a price worse that you wanted.


Interest rate risk applies mainly to bonds and prefered stock.  Changes in interest rate impact the value of the bonds or prefered stock.  Just like a declining market will decrease the value of a generic stock portfolio, rising interest rates will decrease the price/value of bonds and prefered stocks.


Regulatory and legislative risk applies to the idea that agencies may impose stipulations or penalties on an organization or that changing laws will hurt an investment, respectively.


Purchasing power risk is the risk that the buying power of your investment will be less than at time of original investment.  For example, if a portfolio of CDs has gone from $10,000 to $10,200 but the inflation rate has been at 4% then the value of the portfolio has actually decreased by 2% because you would have to have $10,400 just to keep up with inflation!


Different types of investments are for different purposes. Short term savings for things like a new car and emergency funds are great in money markets and similar vehicles but for longer term retirement savings, purchasing power risk has to be kept in mind.



The bottom line is that we have to keep in mind the different types of risk that exist.  Many people are scared of the market because of the volatility (market risk) but purchasing power risk is a risk as well and over the long-run it is much more prevalent in lower yielding investments like Treasuries and money markets than in stocks.