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Investment Risks

All investing involves risk. Most investments involve many different types of risk—anything that creates uncertainty about your investment is a risk. Before you make an investment, you need to determine what risks you are taking and if you can—financially and physically—afford to take those risks. The promoter of the investment should tell you, in writing, what risks are involved in the investment she or he is trying to sell you. You need to determine if you can afford those risks.

The risk you absolutely must not take is the risk that the investment is not legitimate. An iron clad rule about risk is that the higher the potential rate of return on an investment, the higher the risk you are taking that you will not receive that return and, additionally, that you may lose your initial investment. Always investigate the salesperson and the investment before you hand over your money.

Let's assume, however, that you know that the investment is legitimate. You have obtained all of the representations about the investment in writing, you have checked with the securities regulators to make sure the securities and the salespeople are registered, you have investigated the issuer of the securities, and you have read the prospectus. What types of risk should you look for to determine if this investment suits your goals?

  • Market risk: the risk that the price for which you can sell the investment will be lower than the price you initially pay for it. A number of factors impact market risk, including political, economic, and weather conditions. Is the risk high that the market price of the investment will be volatile? If so, can you afford to hold the investment if the price drops until the price comes back up? If you can't hold the investment because you need the money for something else at a specific time, then you can reduce risk by buying a more stable investment.
  • Business risk: the possibility that the transaction underlying an investment will not succeed. You can lose money if the company's competitors are better than the company, people don't buy the company's products, or the company's officers don't manage the company well or are dishonest. You can lower the business risk by investing in a business that is established and has a successful track record, that is run by experienced business people, and that sells a product in which consumers have proven to be interested.
  • Liquidity risk: the risk that you will not be able to sell the investment quickly if you need or want to. An investment in exchange-traded securities is very liquid because you can buy or sell the securities any time the exchange is open. An investment in a limited partnership that owns raw land may not be as liquid if no one is interested in that parcel of land when you want to sell your interest.
  • Inflation risk: the chance that the value of investments will be eroded as inflation shrinks the value of the country's currency. You run the risk that inflation will erode the value of your investment if the return you receive on the investment is lower than the inflation rate.

As in all things, you must ascertain and maintain the appropriate balance between the risks you can afford and are willing to take and the return you would like to receive on your investment.

By W. Mark Sendrow
Director of The Arizona Corporation Commission Securities Division
Article Date: 03-29-2002

The Arizona Corporation Commission disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author and do not necessarily represent the views of the Arizona Corporation Commission.

 

 
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