Market Risk And Inflation Risk

Market risk

People talk about the market and how it goes up or down, making it sound like a monolithic entity instead of what it really is a group of millions of individuals making daily decisions to buy or sell stock. No matter how modern our society and economic system, you can’t escape the laws of supply and demand. When masses of people want to buy a particular stock, it becomes in demand, and its price rises. That price rises higher if the supply is limited. Conversely, if no one’s interested in buying a stock, its price falls. Supply and demand is the nature of market risk. The price of the stock you purchase can rise and fall on the fickle whim of market demand. Millions of investors buying and selling each minute of every trading day affect the share price of your stock. This fact makes it impossible to judge which way your stock will move tomorrow or next week. This unpredictability and seeming irrationality is why stocks aren’t appropriate for short-term financial growth.

In April 2001, a news program reported that in 2000, a fellow with $80,000 in the bank decided to take his money and invest it in the stock market. Because he was getting married in 2001, he wanted his money to grow faster and higher so that he could afford a nice wedding and a down payment on the couple’s future home. What happened? His money shrank to $11,000, and he had to change his plans. Sometimes, market risk begets romantic risk. Losing money is only one headache you face when you lose money this way; the idea of postponing a joyful event, such as a wedding or a home purchase, just adds to the pain. The gent in the preceding story could have easily minimized his losses with some knowledge and discipline.

Markets are volatile by nature; they go up and down, and investments need time to grow. This poor guy (literally, now) should have been aware of the fact that stocks in general aren’t suitable for short-term goals. Despite the fact that the companies he invested in may have been fundamentally sound, all stock prices are subject to the gyrations of the marketplace and need time to trend upward.

Investing requires diligent work and research before putting your money in quality investments with a long-term perspective. Speculating is attempting to make a relatively quick profit by monitoring the short-term price movements of a particular investment. Investors seek to minimize risk, whereas speculators don’t mind risk because it can also magnify profits. Speculating and investing have clear differences, but investors frequently become speculators and ultimately put themselves and their wealth at risk. Consider the married couple nearing retirement who decided to play with their money to see about making their pending retirement more comfortable.

They borrowed a sizable sum by tapping into their home equity to invest in the stock market. What did they do with these funds? You guessed it they invested in the high-flying stocks of the day, which were high-tech and Internet stocks. Within eight months, they lost almost all their money. Understanding market risk is especially important for people who are tempted to put their nest eggs or emergency funds into volatile investments such as growth stocks (or mutual funds that invest in growth stocks or similar aggressive investment vehicles). Remember, you can lose everything.

Inflation risk

Inflation is the artificial expansion of the quantity of money so that too much money is used in exchange for goods and services. To consumers, inflation shows up in the form of higher prices for goods and services. Inflation risk is also referred to as purchasing power risk. This term just means that your money doesn’t buy as much as it used to. For example, a dollar that bought you a sandwich in 1980 barely bought you a candy bar a few years later. For you, the investor, this risk means that the value of your investment (a bond, for example) may not keep up with inflation.

Say that you have money in a bank savings account currently earning 4 percent. This account has flexibility if the market interest rate goes up, the rate you earn in your account goes up. Your account is safe from both financial risk and interest rate risk. But what if inflation is running at 5 percent? At that point you’re losing money.