Notes

Business Risks
risk that losses will occur because of failures in some or all of the process. We call these business operational risks because, in order to be avoided, they are dependent upon the flawless execution of business operations.

For example, a manufacturer is dependent upon suppliers of raw materials, production line operations, employee performance, physical plant integrity, and even intangibles such as the weather to be assured that the profit margin is generated and maximized. A breakdown in any of these variables can be a risk to the forecasted performance and to the profits possibly realized.

Financial Risks
Financial risks, like operational risks, exist for all businesses. Financial risk refers to an inability of a business to cover the financial obligations incurred from operations of that business.

In real estate, this is possible because most real estate is purchased with large amounts of borrowed money. To be profitable, real estate investments must return enough money to pay back any loans taken out to purchase them, as well as whatever operating expenses are involved. Since loans take many years to repay, an investment must be profitable through all or most of those years to pay for itself. Though accurate market analysis and property valuation techniques can help to minimize risk, there are too many unforeseen factors that can increase the risk.

For example, suppose an investor purchases a small strip mall next to a large grocery store. The strip mall's tenants are all small businesses that derive most of their clientele from the grocery store's patrons. If the grocery store decides to move its location to a larger, newly built space down the street, or if it goes out of business, the smaller businesses are likely to follow it; either to the new location or risk failure. Either way, the investor who owns the building is now stuck with an empty building, and now must, most likely, charge lower rents to attract clients. Also, if it becomes necessary to sell the property, it will generate less than the original cost to purchase.

Purchasing Power Risk
Purchasing power risk is the risk that the capital invested will decline in value because of inflation.

For example, an investor invests in a bond that pays six percent per year. With the six-percent interest rate, the investor has covered an expected four-percent annual inflation, plus two percent to cover the credit risk of the company and give the investor a real return on his or her investment. However, immediately thereafter, inflation rises to 10 percent per year. Instead of a positive real return, the investor will receive a negative four-percent return on his or her investment.

Changes in inflation can sometimes be predicted by following the actions of the federal government in setting monetary and fiscal policy, but predictions are never 100 percent accurate. As long as expected inflation can vary from actual inflation, the investor faces purchasing power risk.

Interest Rate Risk
As we have seen, interest is the rent paid on money. Interest rates are determined by the market—the individual lenders—but are also influenced by the Federal Reserve's open market activities and its primary lending discount rate (the interest rate the Federal Reserve charges to other banks).

Interest rates are inversely correlated with property values. That is, rising interest rates cause falling property values, and falling rates cause values to rise.

Interest Rate Risk
Likewise, when interest rates increase, the price of existing, fixed-income investments decreases. If an investor buys a bond or a preferred stock paying a fixed rate per year and interest rates increase, the price of the bond or preferred stock will drop. An investor wishing to sell the security before maturity will have to take a price at a discount from the original price, because the purchaser will expect to receive the higher yield.

Rising interest rates can have a negative effect on stocks, too. Higher interest costs for a company can reduce earnings, thus reducing the market value of shares. Also, as interest rates rise, expected returns on stocks rise. An increase in interest rates may force the share prices down as investors switch from stocks to bonds and as new investors in stocks offer lower prices in order to obtain a higher yield on their investment.

Risks that Affect Return
It is not just the continuation of an existing investment that must be considered when assessing risks. Also of concern is the eventual resulting return on that investment. Without the delivery of good returns, investments seem rather pointless. Risks involved in this are:
Liquidity Risk
Some investments face additional risk because there is no secondary market in which investors in those instruments can quickly sell or redeem their investment without taking a loss. The more liquid (easily marketable or redeemable) a security is, the more quickly an investor can react to changes in the market or the need for quick cash. Treasuries, money market funds, bonds of highly rated companies, and shares sold on the national exchanges are highly marketable as are mutual funds which are easily redeemable.

However, like real estate investments, some investments in private companies or collectibles may be impossible to transfer quickly without a significant loss of capital. Therefore, investors should only invest in non-liquid assets with funds they will not need in the foreseeable future.

Safety Risk
One other risk factor to consider in investing concerns the possible loss of capital due to conditions that cannot be foreseen. Because of this unanticipated aspect, we'll refer to these risks as safety risks. The two primary risks involved here are market and default risk.

Market Risk
Market risk is a type of safety risk that the general investment market will decline, either because of an actual or expected contraction in the economy. While some securities or even whole industries may hold their value or increase in a generally declining market, the majority of financial conditions will follow the trend.

Risk of Default
An investor always faces the possibility of not being able to meet current obligations. This failure might be the result of mismanagement of assets, the acquisition of too much debt, mistiming of new ventures, shrinking of markets, general economic declines or even fraud.

For example:
Bond holders face the risk that the issuer will default on the bonds.

Stock holders face the risk that the issuer will sell off the assets of the company to pay its obligations, reducing future earnings and forcing the stock price down, or that, ultimately, the company will go into bankruptcy.

Real estate investors, for instance, in an apartment community, face the risk that tenants will default on their rent.