Academics and finance professionals sometimes refer to the "risk-free rate of return" as a benchmark; in this context, the risk-free rate is the yield on cash assets, where you're guaranteed stability of principal even as you pick up a slight (these days very slight) return.
But despite the ubiquity of the term "risk-free rate," no investment is 100% free of every possible risk. Even as assets parked in CDs and online savings banks won't fluctuate in value, the investor who parks too much in them can face other types of risks, including inflation risk and shortfall risk. Meanwhile, stocks have a much higher level of risk in the conventional sense, in that you could lose all your money and never recover it. At the same time, an investor who buys and holds a mostly stock portfolio generally faces less of a shortfall risk than the investor who parked the same amount in cash over several decades.
Because each and every investment type entails at least some type of risk, investors would do well to make sure they understand the key risk factors associated with each asset class, build portfolios well diversified across asset classes (and, in turn, risk factors), and don't take more risk than they can afford to, given their time horizons.
Here's an overview of some of the key risks associated with each asset class. Note that some of these risks cut across asset classes--for example, valuation or price risk is primarily associated with holding stocks, but it can affect bond investors, too.
Cash and Cashlike Investments
Inflation Risk: One of the big risks for investors in fixed-rate securities--especially ultra-low-yielding securities like cash--is that their investments may not earn enough to keep up with inflation over time. That's certainly a big risk today: Cash yields are mostly all under 1% right now, but the Consumer Price Index is running in the neighborhood of 1.7%. That means that investors who are holding too much cash today aren't even preserving their purchasing power. The longer the holding period, the more inflation risk should be a concern.
Shortfall Risk: Investors can fall short of their financial goals for many reasons--key among them is undersaving. But if you're saving for a long-term goal, holding too much in investments with little to no short-term volatility--but commensurately low returns--can help exacerbate shortfall risk.
Interest-Rate Risk: Interest-rate risk is the chance that interest rates will increase, thereby pushing down the prices of already-existing bonds with lower yields attached to them. The longer the duration of a bond portfolio, the more vulnerable it will tend to be to interest-rate increases. That's because not only will investors in the long-duration bond be stuck holding a lower-yielding asset when rates increase, but they will be forced to hold on to it for a longer period of time, increasing their opportunity cost. Investors can mitigate interest-rate risk somewhat by holding individual bonds until maturity, but it can be difficult for smaller investors to build well-diversified portfolios composed of individual bonds.
Credit Risk: Credit risk is the possibility that a bond issuer will be unable to pay its debts. To help make up for this risk, bond issuers with lower credit qualities typically must pay their bondholders higher yields than high-quality firms issuing bonds of the same duration. Default risk isn't the only reason that holders of lower-quality credits can run into trouble: In periods of economic hardship, such as the 2008 financial crisis, investors often sell out of low-quality bonds pre-emptively, thereby depressing their prices.
Inflation: As with cash, investors earning a fixed yield on their bond investments will see a decline in their real, take-home yields as prices increase. Treasury Inflation-Protected Securities and I-bonds include an inflation adjustment on top of the yields the bonds offer, thereby effectively removing this risk for bondholders.
Reinvestment Risk: Reinvestment risk generally means that the holder of a security will be forced to reinvest in a less attractive security or environment than the one he or she had originally. For bondholders, this is the risk that bond issuers will refinance their obligations in an effort to lower their interest payments, thereby leaving the bondholder to reinvest the money in a lower-yielding environment. Reinvestment risk has been on full display in the past few years, as many bond issuers have called their bonds featuring higher yields.
Currency Risk: Holders of foreign bonds face all of the risks outlined above, but they may also face a few additional risk factors. One of the most notable is currency risk--the chance that the currency in which the bond is denominated falls relative to the investor's home currency, thereby reducing or even wiping out any appreciation from the bond itself over the investor's holding period. Some foreign-bond funds hedge their currency exposures to effectively wipe out the effects of currency fluctuations on returns, thereby reducing volatility and making returns more bondlike.
Geopolitical Risk: Foreign-bondholders may also see their bonds' prices drop due to geopolitical concerns--for example, political unrest in the country in which an issuer is domiciled. Even if investors in such bonds don't believe that a default is imminent, other investors may demand a higher yield from the bonds to make the risks worth taking, thereby driving down the bonds' prices.
In Part 2 of the article, we’ll continue to look at more risks lurk in other asset classes.