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Investment risk is a reality check. Any kind of investment carries some amount of risk. You will encounter investment risks when you invest. Understand how various risks can affect your investment returns in the article below.
What Is Risk?
Investment risk is the probability of negative financial outcomes rather than expected profit on any particular investment. The possibility of losing the portion or all of the original investment is part of the risk.
9 Types of Investment Risk
1. Market & Volatility Risk
Even if the company performs very well, stocks of the company can still be subject to volatility and market risk. Supply and demand determine stock prices. Stock prices will fall if people pull capital out of the stock market. The market risk is the possibility that a person or other entity would lose money due to variables affecting the overall performance of investments in the financial markets. Diversification among stock and other asset classes can help manage market risk.
2. Inflation Risk
Inflation Risk is the possibility of losing purchasing power due to investments that do not generate returns higher than inflation. If inflation increases at a faster pace than the investment’s returns, the real value or purchasing power of the invested money diminishes. It is crucial for investors to consider inflation risk and aim for investments that yield returns higher than the inflation rate to maintain or increase their purchasing power.
3. Concentration Risk
It is a risk of losing money because your money is concentrated on a single investment or type of investment. Therefore, you need to diversify your portfolio because it will spread the risk among asset classes, industries, and geographic regions, and reduce the concentration risk.
4. Liquidity Risk
Liquidity refers to the ease with which an investment can be bought or sold. The risk of being unable to sell your investments for a fair value when you want to is known as liquidity risk. Some investments, for example, may require you to hold them for a specific period before selling them.
Must Read: What You Need To Know About Liquidity Mining
5. Credit Risk
Technically, credit risk refers to the possibility of loss resulting from a borrower’s failure to fulfil the obligation to repay a loan. In bond investment, credit risk is the risk of a company or the government defaulting on a bond they have issued. The bond issuer may experience financial difficulties. Because of it, they can’t pay the bondholders’ interest or principal, defaulting on their obligations.
6. Reinvestment Risk
The risk of generating lower return if you reinvest your investment returns is known as reinvestment risk. This risk is most common in bond investing but can be related to any cash-generating investment. For instance, buying a bond with dropping yield rates brings a risk of gaining a lower yield rate if proceeds from the bond are reinvested in the same bond.
7. Horizon Risk
Horizon risk is the possibility that your investment timeline (or horizon) will change due to a sudden life event. For instance, losing your job may force you to sell investments to hold for the long term. You may lose money if you have to sell during a down market.
8. Longevity Risk
Longevity risk is the risk that pension funds or insurance companies face when life expectancy and mortality rate assumptions are inaccurate. Longevity risk can be managed to some extent by setting and adjusting the underlying investments, asset allocation, and the amount of income derived from the pension each year.
9. Foreign Investment Risk
Foreign investment risk is the risk of loss when investing in foreign countries. This can include investing in stocks in foreign companies or simply making any investment outside of your country.
10. Understanding Systematic vs. Unsystematic Risk
Investment risk can be broadly categorized into two types: systematic and unsystematic risk. Systematic risk, also known as market risk, affects the entire market or a large segment of it. This type of risk cannot be diversified away. On the other hand, unsystematic risk is specific to a single company or industry and can be mitigated through diversification. Investors need to be aware of both types to manage their portfolios effectively.
11. Political and Regulatory Risk
Investing in foreign markets or even domestically can expose you to political and regulatory risks. Changes in government policies, tax laws, or regulations can significantly impact your investments. For example, a sudden increase in corporate taxes can reduce company profits, leading to a drop in stock prices. Understanding the political climate and regulatory environment of the markets in which you invest is crucial for managing this risk.
12. Interest Rate and Currency Risk
Interest rate risk is particularly relevant for bond investors. When interest rates rise, the prices of existing bonds typically fall, which can lead to capital losses if you need to sell before maturity. Similarly, currency risk affects investments in foreign assets; fluctuations in exchange rates can impact the value of your investments. For instance, if the U.S. dollar strengthens against other currencies, the value of your international investments may decrease when converted back to dollars.
13. Reinvestment and Call Risk
Reinvestment risk occurs when the proceeds from an investment, such as bond coupon payments, are reinvested at a lower rate than the original investment. This risk is common in declining interest rate environments. Call risk, on the other hand, is the risk that a bond issuer might repay a bond before its maturity date, especially when interest rates drop. This could force you to reinvest the principal at a lower interest rate, reducing your overall income.
14. Managing Investment Risks
Effective risk management involves identifying the types of risks your portfolio is exposed to and taking steps to mitigate them. This could include diversifying your investments, choosing assets with lower volatility, or using financial instruments like options to hedge against potential losses. Risk management is not just about avoiding losses but about balancing potential risks with the expected returns.
The Importance of Regular Portfolio Reviews
Regularly reviewing your portfolio is essential for managing investment risk. Market conditions, economic environments, and personal financial goals can change over time, making it necessary to adjust your investment strategy. By conducting periodic reviews, you can ensure that your asset allocation remains aligned with your risk tolerance and financial objectives. This practice helps identify underperforming assets and provides an opportunity to rebalance your portfolio, keeping it on track toward your long-term goals.
Must Read: 6 Tips on How to Build Portfolio Diversification
FAQ
Q: What is the most significant risk for a new investor?
A: Market risk is often the most significant risk for new investors, as it affects the entire market. It’s important to start with a well-diversified portfolio to manage this risk effectively.
Q: How can I protect my investments from inflation risk?
A: To protect against inflation risk, consider investing in assets that tend to outpace inflation, such as stocks or inflation-protected securities like TIPS (Treasury Inflation-Protected Securities).
Q: Is it possible to avoid all types of investment risk?
A: No, all investments carry some degree of risk. However, you can manage and reduce certain risks through diversification, asset allocation, and proper financial planning.
Q: What is the difference between market risk and liquidity risk?
A: Market risk refers to the potential for losses due to factors that affect the overall market, such as economic downturns or changes in interest rates. Liquidity risk, on the other hand, is the risk that you won’t be able to quickly sell an investment at its fair value. While market risk affects the value of your investments, liquidity risk affects your ability to access your funds when needed.
Q: How can I minimize concentration risk in my portfolio?
A: You can minimize concentration risk by diversifying your investments across different asset classes, industries, and geographic regions. This spreads your risk and reduces the impact of a poor performance from any single investment.
Q: What should I consider before investing in foreign markets?
A: Before investing in foreign markets, consider the currency risk, political and regulatory risks, and the economic stability of the country. It’s also important to understand the differences in market practices and regulations compared to your home country.
Q: Why is it important to understand your risk tolerance?
A: Understanding your risk tolerance helps you make investment decisions that align with your financial goals and comfort level. If you invest in assets that are too risky for your tolerance, you might be tempted to sell during market downturns, which could lead to losses.
Q: Can I avoid all investment risks through diversification?
A: While diversification can significantly reduce unsystematic risk (risk specific to individual investments), it cannot eliminate systematic risk, which affects the entire market. Diversification is a powerful tool, but all investments carry some level of inherent risk.
Q: What role does time horizon play in managing investment risk?
A: Your investment time horizon is crucial in managing risk. Generally, longer time horizons allow you to take on more risk because you have more time to recover from potential losses. Shorter time horizons typically require more conservative investments to protect against volatility.