Opportunity Cost
There’s one other type of risk that the exam may ask about: the concept of opportunity cost. This is the idea that every choice investors make to invest their money somewhere potentially represents hundreds (even thousands) of other choices that they could have made to invest somewhere else but didn’t. It’s the risk of not having made the best choice. In other words, which opportunities are you missing out on by investing in a certain security?
An illustration of the concept is to think of a teenager at the mall with $20 in his pocket. If he decides to spend that entire $20 on chocolate, that is $20 he cannot spend on a movie, toys, clothes, or other types of candy. All those other options for which the teenager could have used his money represent the opportunity cost of spending his $20 on chocolate.
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Summary Types of Risk |
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Risk |
Securities affected most by this kind of risk |
Strategies to protect against this type of risk |
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Market risk |
Stocks High yield bonds |
Buy puts on broad based index Short broad-based ETFs |
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Purchasing power risk |
U.S. Treasuries Safe fixed-income securities, such as bonds and preferred stock |
Invest in stocks, REITs, and ADRs |
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Interest rate risk |
Bonds, especially those with high durations Preferred stock |
Invest in stocks and convertible bonds |
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Credit/default risk |
Bonds, especially high-yield bonds |
Invest in safer bonds and stocks, and Treasuries |
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Bu | ||