Broadly, the risk in investing is that an investor may receive less or more income than they expect, that the capital value of their investment can fall as well as rise and that they may lose some or all of their capital.
Risk and Return – The higher the investment risk, the higher the expected return or conversely the higher the expected return, the higher the investment risk. In other words, in order to achieve higher returns investors must be willing to take more risk or if they wish to minimise risk, they must be willing to accept lower returns.
Mismatch Risk – An investment may not be suitable for the investor’s needs, objectives and risk profile. Matching investments with investor’s tolerance for risk and time horizon requires active monitoring as these are subject to change. Longevity risk for example is the risk that an investor will outlive their investments.
Market Risk – Economic cycles, technological, political or legal conditions and even market sentiment cause investment markets and investment returns to rise and fall. Anticipating market timing is very difficult as no two economic cycles are alike.
Lack of Diversification Risk – Investing in a small number of assets or in only asset class exposes investors to higher risk. Diversification across markets, asset classes, market segments, managers and styles reduces overall risk.
Gearing Risk – Gearing or the use of borrowed money can increase the exposure to the underlying investments and as such can magnify losses as well as gains.
Business Risk – Any individual asset or groups of assets can fall in value or fail to deliver expected income for a range of operational, management or business environment reasons. For properties this includes the risk of losing tenants.
Interest Rate Risk – Changes in interest rates can have a negative (as well as a positive) impact on investment values and income returns.
Inflation Risk – The risk that returns and capital value may not keep pace with inflation and that the purchasing power of capital is eroded over time.
Credit Risk – The risk that the institution you have invested with may not be able to make the required interest payments or repay your funds.
Duration Risk – The risk that re-investment terms will have deteriorated by the time the cash from current investments becomes available.
Currency Risk – Investments denominated in overseas currencies can rise and fall when the value of the overseas currency changes in relation to the dollar.
Liquidity Risk – The risk that an investor may not be able to convert the investment readily to cash when they need to either due to an absence of buyers for the investment or an absence of a market in which to sell the investment. The risk that you won’t be able to buy or sell investments quickly for a price that tracks the true underlying value of the asset, or that you won’t be able to sell the investment at all because of a lack of buyers in the market.
Counterparty Risk – Investing involves contracts and counterparty risk is the risk that the other party to the contract cannot meet their obligations under the contract.
Hedge Fund Risk – Hedge funds have potential to deliver positive returns under all market conditions, including falling markets. They typically have low correlation to traditional asset classes and may involve specialised strategies such as short selling, program trading, swaps, arbitrage, and derivatives trading. The risks with hedge funds are that they may charge higher fees; may be poorly regulated; are often highly leveraged; can be highly illiquid; offer low investment transparency and rely heavily on the skill and judgement of the manager.
Growth and Defensive Assets
Investment assets can be divided into two broad classes:
Defensive assets – these include cash and fixed interest (or bonds) and will generally provide predictable, stable and consistent returns over shorter periods. Cash is the least risky investment as its capital value will not change, while fixed interest (or bonds) can lose value when interest rates rise or as credit risk is repriced.
Growth assets – these include listed shares, private equity, property and alternative investments and can deliver higher returns over the long term, but both their value and their income returns can fluctuate in the short term and returns are not readily predictable.
Note that hybrids such as convertible notes, preference shares and even commodities have characteristics of both growth and defensive assets.
Sociopolitical Risk — This involves risk related to political and social events such as a terrorist attack, war, pandemic or elections that could impact financial markets. Such events, whether actual or anticipated, can affect investor attitudes and outlooks, resulting in system-wide fluctuations in stock prices.
Country Risk — The risk that events in the country in which an investment is made could impact general market sentiment. This can occur when a country overhauls its government, changes its policies, or experiences social unrest or war.
Currency Risk — Any change in the exchange rate between two relevant currencies can increase or reduce your investment return. You probably have exposure to currency risk if you own stock in a foreign firm or in a large U.S. company with significant foreign sales.
Interest Rate Risk — This is the risk that the value of a security can fluctuate due to changes in interest rates. Interest rate changes directly affect bonds — as interest rates rise, the price of a previously issued bond falls; conversely, when interest rates fall, bond prices increase. The rationale is that a bond is a promise of a future stream of payments; an investor will offer less for a bond that pays-out at a rate lower than the rates offered in the current market. The opposite also is true.
Purchasing Power Risk — The risk that general increases in the prices of goods and services will reduce the purchasing power of money, and likely negatively impact the value of investments. Inflation and interest rate risks are closely related as interest rates generally go up with inflation. But inflation can also be cyclical. During periods of low inflation, new bonds will likely offer lower interest rates, which may lead investors to higher-risk bonds offering higher rates.
Legal Remedies Risk — The risk that if you have a problem with your investment, you may not have adequate legal means to resolve it. When investing in an international market, you often have to rely on the legal measures available in that country to resolve problems. These measures may be different from the ones you may be used to in the US.
Managing Your Investment Risk
While you cannot avoid investment risk, you can manage and take steps to minimize your exposure. But to do that, you need to first understand the types of risk you face, because different investment products are susceptible to different types or risk.
One of the best ways to manage your risk is to diversify your investments. Both business and market risks can be mitigated to a certain extent by diversification — not just at the product or sector level, but also in terms of region (domestic and foreign) and length of holding periods (short- and long-term). You can spread your international risk by diversifying your investments over several different countries or regions.
On top of that, you can manage your risk by doing your research and indexing. Learn about the forces that can impact your investment. Stay abreast of global economic trends and developments. If you are considering investing in a particular sector, read about the future of that industry. If you are considering investing in a particular country, be sure you understand the local market and political situation.
Finally, consider your options and your own risk tolerance. Learn more about the various types of investments options available to you and their risk levels. Some investment products are more volatile and vulnerable to market risks than others. And some sectors and businesses face more business risks that others.