In a training course that it runs for youth, the US Securities and Exchange Commission reminds students: “The greater the potential return, the greater the risk. One protection against risk is time, and that’s what young people have.” It’s a good reminder for all investors. After all, every investment has different risks and returns, but only you—possibly with the assistance of a financial advisor—can know how much risk you’re willing to take on in each phase of your life.
The general rule in investing is that there’s no guarantee. Broadly speaking, the less risk you take, the lower the potential reward, and the more risk, the higher the potential reward. It’s an investor’s choice to decide how many eggs to put in a potentially risky basket, and how many to put in less risky investments. Knowing the different types of investment risks can help you decide for yourself how much exposure, and to what types of risk, you’re willing to take.
What is investment risk?
There is the simple risk definition—that the possibility something like loss will happen—and then there is a financial risk definition. In finance, risk is usually defined as the possibility that the return you expected from a stock, bond, property, or other security will be lower than your expectation. When you make an investment, you’re accepting the possibility that you could lose some or even all of it.
But there is a way to consider risk that’s not wild speculation. The financial world generally assesses risk in historical terms—by looking at historical investments and their outcomes. Financial experts measure the statistical volatility of assets over time using standard deviation—a formula that shows the difference between prices and a mean. A historically volatile stock would have a high standard deviation, and a more stable investment would have a low standard deviation.
Types of investment risk
Financial experts generally cite these types of risks, and they are broadly categorized as systematic (affecting most of or the total market) and unsystematic risks (specific risks that affect an industry or a company).
Economic developments or world events that affect the entire market result in market risk, which is the possibility of an investment losing value because of market events. This is considered a systematic risk, since it would affect a big chunk of the total market. It can be broken down into three types:
- Equity risk. The market price of shares rises and falls all the time based on supply and demand (propelled by investor optimism or lack thereof). Equity risk is the risk of losing money because of a drop in the market price.
- Interest rate risk. Debt securities like bonds are affected by interest rate risk. In other words, if the interest rate goes up, the market value of a bond will drop.
- Currency risk. When you own foreign investments, the movement in the exchange rate between your currency and the country in which you own an investment can affect the value of your investment in your dollars.
The risk of not being able to sell securities at a fair price and take your cash out is liquidity risk. If an investment can’t be sold quickly enough to prevent losing your initial investment amount, you might have to sell at a lower price.
When you put all those proverbial eggs in a single basket; i.e., concentrate all your money in one type of investment, you risk losing the whole amount if that security loses its value.
Credit or default risk
Debt investments such as bonds can be affected by credit risk, which is the risk that the government or company that issued the bond will default. This is a good reason for looking at the credit rating of a bond, which will tell you how risky the credit rating agencies consider it to be.
When you reinvest principal or income at a lower interest rate than its current rate, you risk the opportunity to earn higher returns. For instance, if you buy a bond paying 6%, you would be affected if the bond matured and you had to reinvest the principal at a lower interest rate.
Inflation gnaws away the purchasing power of money. Consider that most famous example of inflation—the hyperinflation of the German papiermark of the Weimar Republic, which caused the price of a 160-mark loaf of bread in Berlin at the end of 1922 to cost 200 trillion marks by late 1923. That’s an extreme example but illustrates that if your return on investment is lower than inflation, your investment dollar is at risk.
The time horizon is the length of time you expect you’ll hold an investment. Personal events like losing a job or other unforeseen life circumstances may force you to sell investments you’d intended to hold for the long term. If the sale coincides with a lower share price, you could lose money.
Those in the later stages of their careers or at retirement could risk outliving their investments and savings.
Foreign investment risk
When you invest in foreign countries, you don’t only risk fluctuating currencies. Buying investments in emerging markets carry their own risks (civil unrest, economic instability). Any foreign market in which there could be high inflation, falling GDP, or other events could expose your investment to risk. A country might default on obligations, which would affect the stocks, bonds, options, mutual funds—any securities it has issued.
How to measure investment risk
Investors must decide for themselves what their risk threshold, or risk tolerance, will be. Factors like your age, how close you are to retirement, your investment goals (like buying a house or putting kids through college), income, and how liquid you need your money to be will influence your risk tolerance. There’s also an element of general comfort with risk and gut feeling.
Understanding the risk-return tradeoff of an investment (or investment type) can help you assess the risk you’re considering taking on. This is the see-saw effect where you decide where you’re comfortable balancing your tolerance for risk with a desire for a high return.
Importantly, higher risk doesn’t necessarily mean higher returns, since no investment comes with a guarantee. The risk-return tradeoff only refers to the statistical likelihood of higher returns with higher risk. Examining historical predictors of investment risk—measures such as standard deviation—can help you compare investment risks.
How to manage investment risk
Every investment carries with it some measure of risk. But there are ways of managing it.
- Diversification: Dividing investment across asset classes can help buffer a portfolio from the losses it might incur by putting everything in a single investment category that didn’t perform or lost value. Diversifying can mean spreading investments across assets classes and also within asset classes, like investing across different sectors in the stock market.
- Dollar cost averaging: Continually investing money over time in roughly equal amounts can help long-term investors smooth out the effect of shorter-term highs and lows in the market on their portfolios. This practice can help shield you from investing too much into a stock at its high while also allowing you to take advantage of some dips in the market. This is the opposite of trying to time the market.
- Long-term view: Statistically, individual investors underperform the overall stock market, since they’re more likely to buy and sell their positions based on emotion and may not hold their positions long enough to take the long-term benefit. Those who build positions over time and don’t have knee-jerk reactions to the market are more likely to realize long-term gains.
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