UNDERSTANDING INVESTMENT RISK; THERE IS NO SUCH THING AS A FREE LUNCH

Investment risk can be defined as the potential that actual returns will differ from those expected. Generally speaking, the greater the variation in potential gains or losses, the greater the investment risk. Therefore, low-risk investments, such as savings and money market deposit accounts, usually mean lower expected returns than high-risk investments such as commodities and financial futures.

It is important that investors understand that the risk associated with any investment is directly related to its expected return and its expected holding period. Investors should also understand the relationship between the return they can expect on an investment and the amount of risk that they must take to earn that return. In general, investors seeking higher returns must be prepared to assume higher risks or reduced liquidity. Failure to understand this risk-return tradeoff is the primary reason many investors choose the wrong investments and face catastrophic results.

A fundamental principle of investing is that most things come at an opportunity cost. If the investor uses money or other resources in a particular way, those resources cannot be used for anything else at the same time. Every investment choice must be made at some cost. For example, if an investor uses available capital to purchase a mutual fund, that capital cannot be used at the same time to purchase commodities.

There are a number of risks that an individual must weigh when selecting an investment. The most important of these risks, that widen an investment's range of possible return, are:

• Purchasing power risk – Inflation, the general rise in prices over a period of time, tends to reduce purchasing power. As prices increase, the purchasing power of fixed amounts of principal declines. In other words, if investment doesn't grow faster than the rate of inflation, the investor is losing money. Therefore, investors must seek investments that produce a rate of return that compensates for lost purchasing power.
• Interest rate risk - These are often caused by a fluctuation in the supply of, or demand for, money. Interest rates seldom remain stationary for long periods. As they rise and fall, they affect the value of fixed value investments, such as bonds.
• Liquidity risk - Liquidity risk is the possibility that the seller will not find a ready, willing and able buyer for an asset. An individual's investment strategies should include an estimate of the time period over which the assets will be held.
• Market risk - Market risk, using the price of real estate, mutual funds and other investments, may fluctuate because of economic, social or political conditions. For example, investors who are interested in purchasing stocks in multinational corporations, such as IBM or Nestle, should carefully consider the political climate in various countries in which the corporations do business. An unstable government's civil war creates volatile investment environments.

Risk Management; How to Handle Risk?

Risk is unavoidable. By doing nothing, one has chosen a strategy; one that entails risk. By doing nothing (e.g., spending everything) opportunity cost risk is elevated. By failing to put money to work, the effects of inflation are increased. For example, if a dollar buys a certain amount of food today, but buys less 10 years from now, individuals have lost realpurchasing power if they don't act. Additionally, by spending everything, one is exposed to the risks of disability, death or excess longevity.

Just as there are many ways to define risk, there are many ways to deal effectively with

it. There are three basic methods for handling risk.

1. Avoid it. For the same reason some people don't play cards for money, others avoid various risks by choice. By choosing not to purchase stocks, the risk of losing capital if the price of stocks falls is eliminated. It is, however, impossible to avoid simultaneously all forms of risk.

2. Accept it. Before any investment is made, an individual can estimate what the risk might be in relation to the potential return.

3. Minimize it. Risk can be reduced or eliminated by transferring it to another party. Insurance, for example, is a business tool for handling risk by spreading it among a sufficiently large number of similar exposures to predict the individual chance of loss. Hedging, used by commodity futures traders, is an investment strategy to offset or minimize potential damage caused by adverse price changes. Another way to minimize or offset risk is diversification, which is the inclusion of a variety of investment products in one's portfolio.

5 Insurance Policies To Avoid

Fear of the future and uncertainty is one of the best selling tactic used by insurance sales people. Insurance companies understand this fear and use it against you. Before I go any further, I will tell you that insurance must be included in your financial planning strategies. The key is to chose the correct insurance for your situation.

Insurance is about transferring risk - risk that you cannot take or do not want to take. Unfortunately many people waste money on insurance products that they do not need and never will use. Here I share five insurance products that you should avoid:

• Extended warranties - how many times when you go to the electronics store you are asked to buy an extended warranty. These type of policies are rarely used, particularly on small items. If you purchase a product from a reputable manufacturer, must likely it will work as advertised. So do not take the bait!
• Flight insurance - This one is completely unnecessary. Your life insurance policy should already cover you in the event of catastrophe. If you are not certain and you travel a lot, contact your insurance agent.
• Accidental death & dismemberment (aka AD&D) - Unless you are a driving calamity (constantly involved in car accidents), the use of this policy would be near zero. The coverage provided by these policies are covered by most of the reputable health and/or life insurances. Also, the manner these policies are written makes it difficult to collect.
• Mortgage life insurance - they pay off your mortgage in the event of your death. A valid concern, the desire to avoid leaving our families with debt burden. However, you accomplish this through other methods in your financial plan. If you still want to have an insurance to specifically address this concern, then go for decreasing term insurance. 
• Credit card insurance - another money waster, this one pays your credit card bills in the event you cannot pay. Interesting concept. I have a better idea, avoid running your credit cards and becoming a debt slave. This way you do not need to worry about the credit card bills.

There are a variety of insurance policies to choose from, and they all cost money. While it is prudent to maintain certain levels of insurance protection, you must be careful in selecting the right coverage. The goal is to provide your family the greatest protection against risk at the lowest cost possible. Remember the more risk you transfer to the insurance company the more you have to pay in premiums. Always read your insurance policies and ask questions to make sure you understand what you are purchasing and understand its limitations.