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It pays to understand the risks of investing

It's impossible to avoid this money management truism:

It's impossible to avoid this money management truism: No matter what you do, there is some element of risk involved. Credit: iStock

Benjamin Franklin said, "An investment in knowledge pays the best interest."

Unfortunately, all of the education in the world cannot help you avoid a truism of money management: No matter what you do, there is some element of risk involved.

That's why, this week, we are going to conclude my mini-course of the past couple of weeks, "Back to School for Your Money," with a focus on this core concept. My previous columns covered stocks and bonds (Act 2, Sept. 13) and life insurance (Act 2, Sept. 20).

A Merriam-Webster dictionary defines risk as "the possibility that something bad or unpleasant (such as an injury or a loss) will happen." Risk is a four-letter word that can wreak havoc on your retirement plan, your child's education funding and your ability to sleep at night. Unfortunately, most investors equate risk with those investment surveys that ask, "How would you feel about losing 20 percent of your portfolio's value?"

In a bull market, many respond by saying the loss would be acceptable, while in a bear market, it is not.

There are many facets of risk, but the easiest way to start is to look at two major categories: systematic risk, which relates to factors that affect the overall economy, and nonsystematic risk, which is associated with investing in a particular product, company or industry sector.

Here are examples of nonsystematic risk:

Market Risk If you are invested in any asset — stocks, bonds, commodities — you will be subjected to the risk of being dragged down with that overall market. Even the greatest company's stock will drop if the Standard & Poor's 500 index plummets.

Interest-rate risk When interest rates change, many securities will be affected, but the most direct consequence will be seen in bonds. When interest rates increase, bond prices fall; conversely, when they decrease, bond prices rise.

Inflation risk When prices rise, your dollar buys you less, reducing your purchasing power. Inflation also can reduce the value of your investments. For example, to keep pace with inflation and compensate for the loss of buying power, investors need to see an increase in their income from bonds. That means existing bonds will lose value in a high-inflation environment.

Currency risk When you invest in international securities, the exchange rate between that country's currency and U.S. currency can reduce your investment return.

Liquidity risk How quickly can you unload a particular investment? That is the question liquidity risk answers. Liquidity risk will be high for thinly traded or esoteric investments, which may not be easily sold.

Geopolitical risk is the possibility that instability or unrest in one or more regions of the world will affect investment markets. Terrorist attacks, war and pandemics are examples.

Here are examples of nonsystematic risk:

Management risk When you invest in an individual stock, you are subject to management or company risk. Poor management decisions, strategy missteps or even external situations can have an adverse effect on a company's performance and, as a consequence, on the value of investments in that company. Even if you research a company carefully before investing and it appears to have solid management, strange things can happen that are out of an investor's control.

Credit risk, also called default risk, is the possibility that a bond issuer won't pay interest as scheduled or repay the principal at maturity. Credit risk also may be a problem with insurance companies that sell annuity contracts, in which your ability to collect the interest and income you expect is dependent on the claims-paying ability of the issuer.

This list might spook you, but remember, these risks have always been present, though you may have not been aware of them. That said, there is an easy way to guard against — though not to eliminate — such risks.

Your chief defense against systematic and nonsystematic risk is to use an asset allocation strategy, which spreads out your investments across securities that react differently to all of these.

Jill Schlesinger, a certified financial planner, is a CBS News business analyst.

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