| Tuesday, November 24, 2009 |  |
|
Tough Times Series: In a Down Market, It Pays to Know the Financial RisksWhen both investments and jobs can disappear faster than a snowball on a hot griddle, even the news media has gotten a bit bored with the subject of financial risks. But recognizing the types of risk that can cause financial anxiety is key to a reasonably safe, prosperous investment strategy—especially during a time of fear and uncertainty. Meet the four financial risks:
There are any number of other risks. Personal financial risk, caused by changes in your family status or employment, can affect how much you need to earn on investments. And in honor of the largest Ponzi scheme in history—that perpetrated by Bernie Madoff—we remember "rip-off risk": When things seem too good to be true, they usually are. Yet despite the recent Madoff scandal, "most people are dwelling on market risk after the cataclysm on Wall Street that began in fall 2008, says Steve Rick, senior economist at the Credit Union National Association, Madison, Wis. Don't wait until you're in financial trouble to ask for a financial checkup at your credit union.
Some blame for the disappearance of trillions in the value of equity investments goes to the wave of fear that followed the collapses at Bear Stearns and Lehman Brothers. But the meltdown also has roots in business risk, as sinking sales have battered and bruised some of the biggest names in American business. These bottom-line realities have helped sabotage prices for both equities (stocks) and debt (bonds). The result of plunging markets is a search for safe investments, Rick says. "The average American's risk appetite is probably the lowest it has been since the early 1980s, and that is causing a huge flight to quality, liquidity, and safety." Most popular have been federally insured instruments, such as Treasury bills and share certificates/certificates of deposit (CDs), which, when issued by federally insured credit unions, are backed by the National Credit Union Administration (NCUA). However, a safe investment can be expensive due to interest-rate risk. "CDs are not bad for a portion of the portfolio," says Rick, but even though the principal in government-insured CDs is safe, high interest rates can sap value from CDs if you must sell them before maturity. A $1,000 CD paying 2% interest will be worth $1,000 or face value at maturity, but if you must sell it early, and market interest rates have risen above 2%, it will not be worth face value—it will be worth less than face value. A safe investment can be expensive due to interest-rate risk.
The same factors affect corporate bonds, but they also are subject to business risk: A business that goes bankrupt will pay less than full value on its bonds—if it pays anything at all. The true yield on a bond or CD is its interest rate minus the rate of inflation, so during a time of 2% inflation, the real rate of return on a 3% CD is 1%. Thus your investment strategy should also account for inflation risk, which can sap the real value of fixed-income investments. The federal government has issued trillions of dollars worth of guarantees and supports to businesses, which has the effect of increasing the money supply and raising the danger of inflation, Rick says. However, some economists are warning of deflation, a systemic fall in prices that actually raises the real value of fixed-income investments: When prices are falling by 2% per year, a 3% CD really pays 5%. "Don't look just at the published rate," says Rick. "If there is a threat of deflation, these deposits can look pretty good." But deflation itself poses severe risk—that your house and other assets lose significant value as all prices fall, for example. Recognizing the types of risk that can cause financial anxiety is key to a reasonably safe, prosperous investment strategy.
Risks change as business cycles wax and wane, and this example shows that some risks can bring benefits, not just inflict pain. And the low share prices, caused by the market and business risks, eventually will create a buying opportunity, Rick says. "Every prior recession has ended, and if you have the guts, at some point it will be time to put money into the market." Running away from risk can backfire just as much as running toward it, he adds. "In the stock market, typically after a period of low return, you get a reversion to the average, and a period of above-average returns. People are losing now and getting out of the market, but it's the worst time for that." Smart investors say it's time to buy when everybody is selling, Rick adds. "You want to be a contrarian. If you go with the flow, you can get run over." Although falling interest rates have depressed returns on fixed-income investments, they offer opportunities to credit union members. "With interest rates down so dramatically, especially for mortgages, everybody with a home equity loan or a mortgage should be going back for an opportunity to refinance," says Rick. "You can save hundreds of dollars a month. Maybe it's time to restructure all your debt. If you have a bank credit card, charging 21%, maybe it's a good time to get a home equity loan, or a new credit card at the credit union." Credit unions generally offer credit cards at lower interest rates and fees than banks. Most people are dwelling on market risk after the cataclysm on Wall Street.
Finally, just as the meltdown in the housing market has caused a return to basic, comprehensible mortgage products and rates, the recession also is stimulating attention to details. "When incomes are not rising, money management is crucial," says Rick. "We are seeing a significant drop in overdrafts, because nobody is bouncing checks." Although you can manage risks only to some extent, you can control many expenses. When you're facing no prospect of a raise or even a cutback in hours, it's not a time to be paying fees on bounced checks. "People are being smarter," Rick says, "managing their money better, asking how they can restructure their debts, making every penny count." Don't wait until you're in trouble to ask for a financial checkup at your credit union. In fact, the earlier you ask for a review, the better the outcome can be. Neither CUNA nor the author of this article is a registered investment adviser. Readers should seek independent professional advice before making investment decisions. 
Home & Family Finance® Resource Center |
Your Credit Union |