What is Income Risk?

Income Risk DefinedWhen you open up a stock trading account, the securities you choose for online investingwill most likely be a mix of stocks and bonds. The percentage you allocate to each investment vehicle depends mostly on your risk tolerance and timeframe until retirement. Younger investors can choose a more aggressive strategy since time is on their side and they can make up for losses from stock market volatility. Older investors may choose a more conservative strategy since they are either close to retiring or are already retired and need investment income to sustain their lifestyle since they're not working full-time.

Regardless of how your assets are allocated, if you do choose to invest in income-bearing securities, you may want to consider income risk. Stocks aren't the only kinds of investments that have risk factors. Income-bearing investments and money markets have their own sets of risk factors you need to consider before investing.

In a nutshell, income risk is the risk that the income or dividends paid out by a fund will either fluctuate or decrease due to changes or drops in interest rates. An interest rate is the percentage of principle paid to the lender (usually a bank) over a specified period of time like a month or a year. With interest rates, the borrower pays the lender a percentage of the principal (face value or original amount borrowed) for use of assets. The interest is considered a fee paid by a borrower to the lender to compensate for the borrowing the assets.

Income risk is more common in money market and other short-term income-fund securities, rather than longer-term income funds that may lock in interest rates.
Income risk is similar to interest-rate risk. The difference is that income risk is more specific to money market and short-term income funds, whereas interest-rate risk deals more with individual, long-term debt securities.
An example of income risk follows. Jane Smith invests in the ABC Money Market Fund, which has a maturity of less than one year. If interest rates are up at 6%, then the money market yield increases and the fund has a payout of 5.75%. If interest rates drop to 3%, the fund's payout could also drop to a rate of 2.75% because when money markets mature, their returns are reinvested at much lower interest rates.
What This Means for Your Stock Trading Account
Dropping interest rates can mean lower returns if you've invested in bonds or income funds. One of the ways to mitigate risk is to diversify in a variety of investments. This means keeping different assets in your account with your stocks, bonds and mutual funds.
Keep up to date on the changes in the market and rebalance your portfolio if necessary. This means reviewing your portfolio allocations and deciding which assets may be risky and making necessary changes. Younger investors with an aggressive strategy may consider reevaluating and possibly rebalancing their accounts on a quarterly basis. Older investors who are more conservative might consider reviewing their positions and possibly rebalancing them on an annual basis.
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