Risk and Return (part C)
by
Charles Lamson
Economic Risk
Economic risk is the danger the economy could turn against your investment. There are periods of growth. However, there have been many times in the past, and undoubtedly will be more in the future, when stocks decline.
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Even in this period of growth, there were losers in the stock market. Check the stock market tables in your local newspaper, a national business journal, or the internet, and you will find that there are stocks that suffer significant losses even as the market is soaring to new heights.
A rising tide does not lift all stocks. What seemed like a good investment idea at the time may find itself out of favor in a superheated market. Industries like construction that are sensitive to high interest rates often suffer significant stock losses although there is nothing fundamentally wrong with the company.
Foreign imports can flood a market and drive prices so low that domestic companies cannot compete. The economic stability or instability of foreign markets can have negative effects on companies that export their product to these markets or rely on them for parts, and so on.
Obviously, there is not much you can do that will influence global economy. However, you can use some common sense when it comes to your portfolio.
The first and most important rule of managing risk is diversification. Spreading your investments out over different companies in different industries and even different countries is your best defense against economic risk.
Inflation
Inflation is the great value killer. The simple definition of inflation is when too much money is chasing too few goods. When this happens, prices increase and workers demand higher wages to buy goods and services.
At some point, prices become so high that consumers quit buying all but the essentials. When this happens, it is like slamming on the brakes in a car.
Consumer demand for products drops, so companies cut their purchases and reduce payrolls by laying people off.
This is called a recession. Prices fall, people are out of work, and businesses close. If it keeps up for too long, a recession will turn into a depression. In this global economy, many countries will soon feel the effects.
To prevent a recession from becoming a depression, interest rates are lowered to make borrowing more attractive and affordable. Businesses stabilize and begin rehiring workers and workers become consumers again.
In a very simple fashion, what I have just described is called an economic cycle. Economists spend a great deal of their time worrying about such cycles and trying to come up with ways to smooth out the peaks and valleys.
Rising inflation triggers interest rate increases, which undermine investor confidence. When their confidence is shaken, investors often look for places to put their money where it will have some shelter from inflation's acid effects.
In the past, investors have run to gold and gold mutual funds, as well as real estate and some exotic investments, to protect their assets from inflation.
The 1990s were a period of overall lower inflation. The last half, in particular, remained virtually inflation-free despite a roaring economy and high employment. Interest rates were raised several times in preemptive strikes against inflation.
Those of us who remember the 1980s and the horrible effect of inflation on our economy are still nervous that it could come back. However, in his book entitled Alpha Teach Yourself Investing in 24 Hours, Ken Little states:
I am not so confident that our economic controls can provide protection against the devastating effects of inflation.
More on risk and return in the next post. To be continued...
*SOURCE: ALPHA TEACH YOURSELF INVESTING IN 24 HOURS, 2000, KEN LITTLE, PGS. 237-239*
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