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9 financial risks everyone should understand

  • By Chuck Jaffe,
  • MarketWatch
  • – 06/16/2014
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My friend Mike grabbed my arm as he barged into the conversation I was having with some other guys.

"What I really want to know, is where do you think I should invest now?"

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I could have given him the usual answer — that I'm not a financial adviser and that I don't pick investments for people — but instead I answered his question this way:

"That may be what you want to know, but what you need to know first is 'What's your greatest financial fear?'"

Mike, a pilot, immediately answered that he's worried about another layoff. Chris, to his right, is scared of the market having a repeat of the meltdowns he saw in 2000 and 2008. Bob said he worries about outliving his money or needing long-term care.

And so it went for a few minutes, each guy coming up with a few legitimate things to fear, or nodding in agreement with the concerns cited by someone else, as the worries ran from current socio-economic events to providing for a special-needs child, to fear of missing out on the market's gains, to not being able to pay to put the kids through college and more.

Finally, Mike said, "Maybe you just say that what I fear the most is losing money or mismanaging money."

The problem with all of these concerns is that even if you work to solve your biggest fear, you may still feel vulnerable to other worries.

If losing money in the market is your biggest fear and you go to all cash in response, you assuage the big worry, but over time you will have a growing scare that your money isn't keeping pace with inflation or, perhaps, that you will outlive your nest egg.

Moreover, if you take that kind of all-or-nothing position, having everything in cash could leave you afraid that if the market doesn't have a comeuppance soon, you've lost real opportunities to grow your savings.

While an individual's financial fears morph and evolve, risks don't. Certain dangers may be more or less present based on current events and conditions, but the underlying risks don't change.

As a result, it's important for investors to see how their worries align with the various types of risk.

  • Market risk, or "principal risk" is the chance that a downturn (or a bad investment) chews up your money. It's there for both stocks and bonds — when interest rates rise, bondholders will see the market value of their paper shrink — and for most people it's the big bugaboo.
  • Inflation or purchasing-power risk for most people is the "risk of avoiding risk" — the opposite end of the spectrum from market risk — the possibility that you are too conservative and your money can't grow fast enough to keep pace with inflation.
  • Interest-rate risk generally revolves around how rates will change. If you seek a long-term "risk-free return" by putting your money in a bank certificate of deposit, you face the chance that interest rates rise and your assets are stuck at what has become a below-average rate of return.
  • Shortfall risk is about you, personally, more than the market; it's the chance that you won't have enough money to make your goals. You can face shortfall risk by being either too conservative or too aggressive; if you don't believe your portfolio can deliver enough, the best way to address this risk is to save more.
  • Special-situation risk involves your life as well, whether it's the special-needs case, planning for college, saving for a big event like a wedding or something else. Most parents get to a point when paying for college is a key concern — a worry that distracts them from saving more for their own retirement — but those circumstances eventually pass.
  • A close cousin is timing risk , another highly personal factor that hinges on your time horizon. While experts agree that the chance that stocks will make money over the next two decades is high, the prospects for the next two years are murky; if you need your money in two years, you have a worry about timing.
  • Liquidity risk affects everything from junk bonds to foreign stocks. On a broad scale, it can be the chance that investments in a particular country suffer during some sort of credit crisis, or the potential for a thinly-traded stock to crater or for its shares to be difficult to redeem in a crisis. It also occurs in investment products like non-traded REITs, where the investment cannot be sold at its perceived value if the money is needed on a moment's notice.
  • Political risk is the prospect that government decisions will damage the value of your investments. Whether it's the safety of Social Security, the impacts of a policy like Obamacare and how it might affect stocks in your portfolio, tax-law changes or more, this is the chance that broad policy decisions hit home.
  • Societal risk is ultra-big picture, looking at world events. This is what might happen in the event of terrorist attacks, war or catastrophe.

Diversification, of course, involves taking on some or all of these risks, so that no concern comes up and ruins you.

But that's also why you can figure out where to invest "now" by considering your biggest financial worry and playing to that particular type of risk.

Depending on circumstances and your nerves, the best move might be staying in cash and building emergency savings, or it could be exploring micro-cap stocks or emerging markets bonds.

In short, the answer for every guy in that conversation could be different, as it could be if you, your friends, family and co-workers tried to determine "where it's best to invest now."

When you want to know where to invest "next," re-evaluate your situation and, again, adjust based on your concerns at that point.

It may mean that whatever you do now won’t be the choice that makes the most profit or that generates the hottest return, but it does mean that your actions should increase your ability to sleep at night. And that’s a win — no matter what the market does next.

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