Think about all the ways that an investment can lose money. You can list all sorts of possibilities. So many that you may think, “Holy cow! Why invest at all?”

Don’t let risk frighten you. After all, life itself is risky. Just make sure that you understand the different kinds of risk before you start navigating the investment world. Be mindful of risk and find out about the effects of risk on your investments and personal financial goals.

Financial risk

The financial risk of stock investing is that you can lose your money if the company whose stock you purchase loses money or goes belly up. This type of risk is the most obvious because companies do go bankrupt.

You can greatly enhance the chances of your financial risk paying off by doing an adequate amount of research and choosing your stocks carefully. Financial risk is a real concern even when the economy is doing well. Some diligent research, a little planning, and a dose of common sense help you reduce your financial risk. In the stock investing mania of the late 1990s, millions of investors (along with many well-known investment “gurus”) ignored some obvious financial risks of many then-popular stocks. Investors blindly plunked their money into stocks that were bad choices. Consider investors who put their money in DrKoop.com, a health information Web site, in 1999 and held on during 2000. DrKoop.com went into cardiac arrest as it collapsed from $45 per share to $2 per share by mid-2000. By the time the stock was DOA, investors lost millions. RIP (risky investment play!).

Internet and tech stocks littered the graveyard of stock market catastrophes during 2000–2001 because investors didn’t see (or didn’t want to see?) the risks involved with companies that didn’t offer a solid record of results (profits, sales, and so on). Remember that when you invest in companies that don’t have a proven track record, you’re not investing, you’re speculating. Investors who did their homework regarding the financial conditions of companies such as the Internet stocks discovered that these companies had the hallmarks of financial risk — high debt, low (or no) earnings, and plenty of competition. They steered clear, avoiding tremendous financial loss. Investors who didn’t do their homework were lured by the status of these companies — the poster children of booming Internet fortunes — and lost their shirts.

Of course, the individual investors who lost money by investing in these trendy, high-profile companies don’t deserve all the responsibility for their tremendous financial losses; some high-profile analysts and media sources also should have known better. The late 1990s may someday be a case study of how euphoria and the herd mentality (rather than good, old-fashioned research and common sense) ruled the day (temporarily). The excitement of making potential fortunes gets the best of people sometimes, and they throw caution to the wind. Historians may look back at those days and say, “What were they thinking?” Achieving true wealth takes diligent work and careful analysis.

In terms of financial risk, the bottom line is . . . well . . . the bottom line! A healthy bottom line means that a company is making money. And if a company is making money, then you can make money by investing in its stock. However, if a company isn’t making money, you won’t make money if you invest in it. Profit is the lifeblood of any company.

Interest rate risk

Interest rate risk may sound like an odd type of risk, but in fact, it’s a common consideration for investors. Be aware that interest rates change on a regular basis, causing some challenging moments. Banks set interest rates, and the primary institution to watch closely is the Federal Reserve (the Fed), which is, in effect, the country’s central bank. The Fed raises or lowers interest rates, actions that, in turn, cause banks to raise or lower interest rates accordingly. Interest rate changes affect consumers, businesses, and, of course, investors.

The scenario outlined in the following paragraphs gives you a generic introduction to the way fluctuating interest rate risk can affect investors in general.

Suppose that you buy a long-term, high-quality corporate bond and get a yield of 6 percent. Your money is safe, and your return is locked in at 6 percent. Whew! That’s a guaranteed 6 percent. Not bad, huh? But what happens if, after you commit your money, interest rates increase to 8 percent? You lose the opportunity to get that extra 2 percent interest. The only way to get out of your 6 percent bond is to sell it at current market values and use the money to reinvest at the higher rate.

The only problem with this scenario is that the 6 percent bond is likely to drop in value because interest rates rose. Why? Say that the investor is Bob and the bond yielding 6 percent is a corporate bond issued by Lucin-Muny (LM). According to the bond agreement, LM must pay 6 percent (called the “face rate” or “nominal rate”) during the life of the bond and then, upon maturity, pay the principal. If Bob buys $10,000 of LM bonds on the day they are issued, he gets $600 (of interest) every year for as long as he holds the bonds. If he holds on until maturity, he gets back his $10,000 (the principal). So far so good, right? The plot thickens, however.

Say that he decides to sell the bond long before maturity and that, at the time of the sale, interest rates in the market have risen to 8 percent. Now what? The reality is that no one is going to want his 6 percent bond if the market is offering bonds at 8 percent. What’s Bob to do? He can’t change the face rate of 6 percent, and he can’t change the fact that only $600 is paid each year for the life of the bond. What has to change so that current investors get the equivalent yield of 8 percent? If you said, “The bond’s value has to go down,” . . . bingo! In this example, the bond’s market value needs to drop to $7,500 so that investors buying the bond get an equivalent yield of 8 percent. (For simplicity sake, I left out the time it takes for the bond to mature.) Here’s how that figures:

New investors still get $600 annually. However, $600 is equal to 8 percent of $7,500. Therefore, even though investors get the face rate of 6 percent, they get a yield of 8 percent because the actual investment amount is $7,500. In this example, no financial risk is present, but you see how interest rate risk presents itself. Bob finds out that you can have a good company with a good bond, yet you still lose $2,500 because of the change in the interest rate. Of course, if Bob doesn’t sell, he doesn’t realize that loss.

You can lose money in an apparently sound investment because of something that sounds as harmless as “interest rates have changed.”

Market risk

People talk about the market and how it goes up or down, making it sound like a monolithic entity instead of what it really is — a group of millions of individuals making daily decisions to buy or sell stock. No matter how modern our society and economic system, you can’t escape the laws of supply and demand. When masses of people want to buy a particular stock, it becomes in demand, and its price rises. That price rises higher if the supply is limited. Conversely, if no one’s interested in buying a stock, its price falls. Supply and demand is the nature of market risk. The price of the stock you purchase can rise and fall on the fickle whim of market demand. Millions of investors buying and selling each minute of every trading day affect the share price of your stock. This fact makes it impossible to judge which way your stock will move tomorrow or next week. This unpredictability and seeming irrationality is why stocks aren’t appropriate for short-term financial growth.

In April 2001, a news program reported that in 2000, a fellow with $80,000 in the bank decided to take his money and invest it in the stock market. Because he was getting married in 2001, he wanted his money to grow faster and higher so that he could afford a nice wedding and a down payment on the couple’s future home. What happened? His money shrank to $11,000, and he had to change his plans. Sometimes, “market risk” begets “romantic” risk. Losing money is only one headache you face when you lose money this way; the idea of postponing a joyful event, such as a wedding or a home purchase, just adds to the pain. The gent in the preceding story could have easily minimized his losses with some knowledge and discipline.

Markets are volatile by nature; they go up and down, and investments need time to grow. This poor guy (literally, now) should have been aware of the fact that stocks in general aren’t suitable for short-term (one year or less) goals. Despite the fact that the companies he invested in may have been fundamentally sound, all stock prices are subject to the gyrations of the marketplace and need time to trend upward.

Investing requires diligent work and research before putting your money in quality investments with a long-term perspective. Speculating is attempting to make a relatively quick profit by monitoring the short-term price movements of a particular investment. Investors seek to minimize risk, whereas speculators don’t mind risk because it can also magnify profits. Speculating and investing have clear differences, but investors frequently become speculators and ultimately put themselves and their wealth at risk. Don’t go there! Consider the married couple nearing retirement who decided to play with their money to see about making their pending retirement more comfortable. They borrowed a sizable sum by tapping into their home equity to invest in the stock market. (Their home, which they had paid off, had enough equity to qualify for this loan.) What did they do with these funds? You guessed it; they invested in the high-flying stocks of the day, which were high-tech and Internet stocks. Within eight months, they lost almost all their money. Understanding market risk is especially important for people who are tempted to put their nest eggs or emergency funds into volatile investments such as growth stocks (or mutual funds that invest in growth stocks or similar aggressive investment vehicles). Remember, you can lose everything.

Inflation risk

Inflation is the artificial expansion of the quantity of money so that too much money is used in exchange for goods and services. To consumers, inflation shows up in the form of higher prices for goods and services. Inflation risk is also referred to as purchasing power risk. This term just means that your money doesn’t buy as much as it used to. For example, a dollar that bought you a sandwich in 1980 barely bought you a candy bar a few years later. For you, the investor, this risk means that the value of your investment (a bond, for example) may not keep up with inflation. Say that you have money in a bank savings account currently earning 4 percent. This account has flexibility — if the market interest rate goes up, the rate you earn in your account goes up. Your account is safe from both financial risk and interest rate risk. But what if inflation is running at 5 percent? At that point you’re losing money.

Tax risk

Taxes (such as income tax or capital gains tax) don’t affect your stock investment directly. Taxes can obviously affect how much of your money you get to keep. Because the entire point of stock investing is to build wealth, you need to understand that taxes take away a portion of the wealth that you’re trying to build. Taxes can be risky because if you make the wrong move with your stocks (selling them at the wrong time, for example), you can end up paying higher taxes than you need to. Because tax laws change so frequently, tax risk is part of the risk-versus-return equation, as well. It pays to gain knowledge about how taxes can impact your wealth-building program before you make your investment decisions.

Political and governmental risks

If companies were fish, politics and government policies (such as taxes, laws, and regulations) would be the pond. In the same way that fish die in a toxic or polluted pond, politics and government policies can kill companies. Of course, if you own stock in a company exposed to political and governmental risks, you need to be aware of these risks. For some companies, a single new regulation or law is enough to send them into bankruptcy. For other companies, a new law could help them increase sales and profits. What if you invest in companies or industries that become political targets? You may want to consider selling them (you can always buy them back later) or consider putting in stop loss orders on the stock. For example, tobacco companies were the targets of political firestorms that battered their stock prices. Whether you agree or disagree with the political machinations of today is not the issue. As an investor, you have to ask yourself, “How do politics affect the market value and the current and future prospects of my chosen investment?”

Personal risks

Frequently, the risk involved with investing in the stock market may not be directly involved with the investment or factors directly related to the investment; sometimes the risk is with the investor’s circumstances. Suppose that investor Ralph puts $15,000 into a portfolio of common stocks. Imagine that the market experiences a drop in prices that week and Ralph’s stocks drop to a market value of $14,000.

Because stocks are good for the long term, this type of decrease is usually not an alarming incident. Odds are that this dip is temporary, especially if Ralph carefully chose high-quality companies. Incidentally, if a portfolio of high-quality stocks does experience a temporary drop in price, it can be a great opportunity to get more shares at a good price.

Over the long term, Ralph would probably see the value of his investment grow substantially. But, what if during a period when his stocks are declining, Ralph experiences financial difficulty and needs quick cash? He may have to sell his stock to get some money.

This problem occurs frequently for investors who don’t have an emergency fund or a rainy day fund to handle large, sudden expenses. You never know when your company may lay you off or when your basement may flood, leaving you with a huge repair bill. Car accidents, medical emergencies, and other unforeseen events are part of life’s bag of surprises — for anyone. Be sure to set money aside for sudden expenses before you buy stocks. Then you aren’t forced to prematurely liquidate your stock investments to pay emergency bills. You probably won’t get much comfort from knowing that stock losses are tax deductible — a loss is a loss. However, you can avoid the kind of loss that results from prematurely having to sell your stocks if you maintain an emergency cash fund. A good place for your emergency cash fund is in either a bank savings account or a money market fund.

Emotional risk

What does emotional risk have to do with stocks? Emotions are important risk considerations because the main decision makers are human beings. Logic and discipline are critical factors in investment success, but even the best investor can let emotions take over the reins of money management and cause loss. For stock investing, you’re likely to be sidetracked by three main emotions: greed, fear, and love. You need to understand your emotions and what kinds of risk they can expose you to.