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Get Four
|  | MAY 5, 2005
 MARKET VIEWS By Beth Piskora Risk: The Rules of the GameHere's a primer on the most common factors that could endanger your portfolio -- and what you can do to minimize their impactThe path to financial reward is strewn with unavoidable risks. Investors must first understand the nature of risk in order to control it in their portfolios. Even someone who keeps his life savings under a mattress is susceptible to hazards; the cash could be stolen or, if it's not, inflation may erode its value. But inflation is just one of the major types of risks investors face. There are others lurking as well: interest rate risk, event risk, and currency risk. Just how can they take a bite out of your assets? Let's take a look. Inflation risk refers to the tendency of currency to lose value over time. In the U.S., $1 buys less than it did five years ago. A first-class postage stamp in 2000 cost 33 cents; now it costs 37 cents to mail a Mother's Day card. And it's not just stamps. The U.S. government says a basket of goods that cost $100 in 1970 cost $447 by 2000. So, to maintain the lifestyle you have today, you will probably need to spend more money in the future. Stocks have been the asset class that best outpaces inflation over long periods and best maintains purchasing power. Over short periods, however, stocks and other asset classes can be volatile. In many cases, the volatility comes down to event risk. Sometimes an event is a geopolitical occurrence that affects the entire market, like September 11's terrorist attacks. DIVERSIFY, DIVERSIFY. The sell-off in their aftermath hurt stocks in every sector of the economy. Over the long term, individual stocks tend to move in concert with the overall market, so it's important to diversify across different asset classes. Individual stocks can also be hurt by bad news emanating from their sector or industry. For example, if one managed-care company announces a profit shortfall, investors may dump the shares of other outfits in that industry. That's an example of sector-specific or industry-specific event risk. The last type of event risk is specific to the company: A management change, an earnings warning, a missed shipment. To reduce sector-, industry-, or stock-specific event risk in your portfolio, you should consider holding a variety of names in each asset class and diversifying among different sectors. JITTERS OVER HIKES. Another concern for investors is interest-rate risk, whereby a security can decline in value as a result of a rise in interest rates. Bond prices move in inverse relation to interest rates, as do the prices of real estate investment trusts (REITs), which are popular among income-oriented investors. Through late April, REITs in the S&P 1500 stock index (which encompasses the S&P 500, MidCap 400, and SmallCap 600) recorded year-to-date losses of about 8%. Many market observers attribute the decline to fears about interest rate hikes by the Federal Reserve. Bonds, which have enjoyed nice rallies in recent years, are not rallying this year, also in part because of jitters about rising interest rates. Investors do not want to buy a fixed-income security today when they reckon the yield could be higher in a few months. KIWI GAMBIT. The Fed has already increased short-term interest rates eight times since June, 2003, from a federal funds rate of 1% to the current level of 3%. S&P's economists believe the Fed will continue to boost rates, and expect the short-term rate to be between 4% and 4.5% at the end of this year. The Investment Policy Committee at S&P recommends investors stick to short- to intermediate-term fixed-income instruments in the bond portion of their portfolios. As yields creep higher, investors will have the chance to exchange lower-yielding securities for higher-yielding ones. Currency risk comes into play for people who invest in foreign securities. When investing in CDs, stocks, or bonds outside the U.S., investors must be aware of what currency conversion rates will do to their investment. Case in point: One reader of S&P's weekly investing newsletter, The Outlook, seeking higher yields than are available in U.S. money market funds, recently purchased a three-month certificate of deposit from a New Zealand bank. The promised yield was 5.25%. That must have seemed pretty appealing, especially with U.S. CDs yielding far less. EXPECT THE UNEXPECTED. However, during those three months, the New Zealand currency fell against the U.S. dollar. In the end, this investor was left with about the same amount of money he would have made in a U.S. money market fund. At the same time, he took on much more risk, since the CD issued in New Zealand was not FDIC-insured. And if the New Zealand dollar had fallen even more, he could have lost money in what he thought was a safe investment. As the Outlook reader's experience shows, investing risk can strike in unexpected ways. A better understanding of how it may affect your portfolio can go a long way toward mitigating its impact.  Piskora is a senior editor for Standard & Poor's weekly investing newsletter, The Outlook All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is or will be, directly or indirectly related to the specific recommendations or views expressed in this research report. Standard & Poor's Regulatory Disclosure Any advice, analysis, or recommendations contained in articles labeled "Insight from Standard & Poor's" reflect the views of Standard & Poor's, which operates separately from and independently of BusinessWeek Online. It is possible that BWOL may from time to time publish information that is not consistent with advice, analysis, or recommendations that are published by Standard & Poor's. Standard & Poor's and BusinessWeek Online are each units of The McGraw-Hill Companies, Inc.
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