Financial Perspectives – Summer 2009

The Many Faces of Risk

For investors, “reward” can be broadly defined as the return on an asset – whether in the form of income it generates or a price increase over a given period. Defining risk, however, is a bit more complex.

An important part of investing is determining if you are taking an acceptable risk in exchange for an achievable, desirable return. Key to that determination is understanding the amount and type of risk you are willing to assume. While specific risks apply to particular investments, many securities share some types of risk, including:

Inflation risk. Rising inflation reduces the purchasing power of both investment income and principal. Fixed income investors typically focus on their real rate of return – the return minus the rate of inflation – while equity investors seek growth at a rate that outpaces inflation.

Liquidity risk. Liquidity refers to the ability to sell an investment quickly, at a fair market price. For example, if you have a fire sale – whether of collectibles, real estate or partnership interests – although buyers may abound, you may have to reduce the price you can expect to receive.

Company-specific or idiosyncratic risk. This risk relates to factors and developments unique to the particular firm’s business, such as the risk that a particular publisher’s printing press may fail.

Market risk. A risk of this type is typically shared not only by all members of the same class but by the market as a whole. For example, the price of pianos has declined, as has the price of musical instruments in general. This type of risk cannot be eliminated by diversification.

To help protect against these risks, well-constructed portfolios typically consist of several asset classes. The most common of these are stocks and bonds, which – like most investments – carry with them risks of their own.

Equities

Just as the biggest potential benefit of owning common stock is making money through price appreciation, the biggest risk is that the stock’s value declines – resulting in a loss should you sell. This risk may be a function of volatility, simply put, the rate at which a stock’s price fluctuates over time. One or more of the risks mentioned may also play a role in pushing a stock’s price down.

You can reduce your overall risk by diversifying your stock investments in a variety of companies of different sizes or in an array of industries.

A few factors you might consider when evaluating an individual stock include the industry in which the company operates, its position within that industry, the quality of its management, projected revenue growth, profit margins, capitalization and the stock’s market price relative to its fair value.

Fixed Income

Corporate bonds, Treasury and U.S. government and municipal bonds, along with brokered CDs and preferred securities, are the most common fixed income securities. They provide opportunities for predictable cash flows and capital preservation.

However, while the interest – or “coupon” – that bonds pay and the maturity date are generally fixed, bond prices fluctuate daily. If a bond is sold prior to maturity, market, liquidity and other risks may come into play, possibly pushing the sales price down.

Fixed income securities are often subject to other risks, including:

Credit risk. Bonds with lower – or no – credit ratings usually offer investors higher yields to compensate for the increased likelihood of default. Similarly, a change in the credit rating or the market’s perception of the issuer’s business prospects will affect the bonds’ value. Ratings also do not remove market risk.

Interest rate risk. Prior to maturity, changes in interest rates affect bond prices. An inverse relationship typically exists between interest rates and fixed income prices: When interest rates decline, bond prices increase; when rates increase, prices decline.

Other risks involving stocks, bonds and other assets – ranging from real estate to private equity; from commodities to collectibles – also exist. Even choosing not to invest carries risk – the possibility that, at the end of the day, you will not have the money you need to meet your objectives.

While finding the appropriate balance between the type and level of risk you assume and the returns you need can be difficult, your financial advisor can help you determine the asset allocation most appropriate to your situation.

For more information about the risks associated with different asset classes, please visit raymondjames.com/investmentproducts.

There is no assurance any of the trends mentioned will continue in the future.

Raymond James & Associates and Raymond James Financial Services are wholly owned subsidiaries of Raymond James Financial, Inc. (NYSE-RJF).

The information contained in this newsletter has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. We may, from time to time, have a position in the securities mentioned and may buy or sell such securities in the course of regular business.

Diversification and asset allocation do not ensure a profit or protect against a loss. U.S. government bonds are guaranteed by the U.S. government and, if held to maturity, offer a fixed rate of return and guaranteed principal value. U.S. government bonds are issued and guaranteed as to the timely payment of principal and interest by the federal government. Municipal bond interest is not subject to federal income tax but may be subject to AMT, state or local taxes. Brokered CDs involve market risk regarding their principal value, unlike traditional bank CDs. If a brokered CD is sold prior to maturity, the value of the CD will be subject to market fluctuations. This could result in a significant loss from the initial investment amount. Preferred securities are considered fixed income investments as their income payments are fixed over the term of the investment and will react similarly to other debt investments to changes in the market conditions.