Risk is a factor of investing that you cannot shake off. Understanding the risks before investing is crucial to ensure your decisions are aligned with your risk tolerance, investment goals, and serenity. If you think you can avoid the risk of investing or if someone offers you risk-free investment options, know that you are served with a myth. If you want risk-free returns, treasury bills should be your pick but with that comes lower returns, too. The question to address here is which are the investment risks you need to know and why! Well, read this article to know more.
The Balance of Risk and Return
Risk comprises the uncertainties that you have to face regarding returns and losses in an investment. Risk means you might not gain the return that you expected or even lose out the whole of your capital.
With risk/return tradeoff means that the higher risk that you perceive for an investment, the higher the expectation for the returns will be and vice versa. When you hear that investment yields greater returns with low risk, there are high chances that this rumor is not true. We have composed a list of investment risks you need to know. Let’s get into it.
Investment Risks You Need to Know
1. The Market Risk
The market is dynamic and the price of stocks reacts to it by falling or going up which is often not known to investors and can be good or bad for their investment.
This risk is also called the systematic risk as it is uncertain, not in your control, has an impact on the financial market, and you cannot diversify it entirely. The market risk related factors include inflation, interest rates, exchange rates, regulations, and economical changes.
2. The Inflation Risk
Inflation risk is also called the purchasing power risk. This risk entails inflation; the purchasing power of your return falls with time. This risk is mostly associated with fixed-income investments.
If the inflation rate is high, your investment in GICs, T-bills lose value and you can even lose out on your funds. As the inflation rate increases, your returns may turn negative. For example, a Certificate of Deposit today can be $100 with an annual interest of $2%, meaning, you will get $102 at the end of the year. But if the inflation rate is 3%, the value of your investment would be $99.
This is the reason that you must diversify your investments to avoid such risks. During inflation, gold is a commodity that performs well.
3. The Currency Risk
Investing in currencies holds great importance for diversifying your portfolio. However, you will also have to face the risks of market fluctuations.
Your investment may rise or fall based on the performance of the currency you invest in against your home currency. It also means that if there is any change in the country’s economic situation or regulation for which you are invested, it will affect the currency rates as well.
4. The Interest Rate Risk
Even the Guaranteed Investment Certificates (GICs) and bonds are also not immune to fixed income investment risks. If the interest rates hikes, the bond price will fall, and if the interest rates go down, the bond price rises. If you want to sell your bond before it matures and the rates are down, you will have to sell your bond at a discount.
For fixed-rate GICs, when the interest rate increases, the rate of return remains stagnant, and hence you will be losing funds on the GIC. This leads to opportunity risk, as you could have invested that money somewhere else.
5. The Economic Risk
Economic events that concern the nation such as economic booms or recessions affect the overall financial market. This is one of the most crucial investment risks you need to know before investing and have to keep yourself updated with the changes in the country’s policy.
We can take the example of the financial crisis of 2008 or the crisis of 1987! The economies became depressed on a global scale and the stock market fell down.
6. The Credit Risk
Credit risk is also called business risk or default risk. Investors who invest in fixed income securities like GICs often come across credit risk because a bond issuer may not meet their obligations like paying interest or returning the principal amount upon maturity. The creditworthiness of the issuer is depicted by the credit rating agencies like Moody’s, Fitch, and S&P.
Stockholders get the wind of this credit risk when the companies are bankrupt and they need to pay their creditors at priority. Companies need to pay their bondholders and preferred shareholders first. If the assets deplete after that, common shareholders can lose all of their investment.
7. The Volatility Risk
The risk of volatility entails that the prices in the market can race up or down due to factors that you cannot anticipate or control.
These changes create unrest amongst the investors and they coerce them to make impulsive moves like selling stocks or buying them at the bottom or top.
Volatility manipulates the investors and triggers behavioral biases that can lead to massive losses. And this happens a lot more often than we can imagine making them very tricky investment risks you need to know!
8. The Socio-political Risk
The tribulations from the social or political events affect your investments. This can happen due to climate disasters, new government policies or regulations, war, unemployment, terrorism, government overtaking public companies to nationalize them, etc. The recent example we can take is the US-China trade war. The market was affected significantly due to that.
This risk affects the market and changes the course of business activities while affecting the dividends and profits for shareholders and companies respectively.
9. The Liquidity Risk
The risk of liquidity is the risk you face while selling or selling your position. This means that you might not find a way or the other party viable enough to buy or sell your investments.
For instance, if you need to sell a stock in the market while it is thin, you might have to sell your stock at discount or you may also find it difficult to get an investor for the same. That is called an illiquid market. The market should be liquid so you can settle your position and make money out of it.
10. The Concentration Risk
If you focus on only one company and its assets, concentration risk arises. An investment in a single asset class increases the propensity for risk. This risk can be averted if you have a diverse portfolio with multiple investments. While this is not a major risk, it is still one of the investment risks you need to know.
11. The Reinvestment Risk
This is the risk that enters your life when your investment matures, and you find no profitable avenue to invest it in.
For instance, if a bond matures and you are looking to invest the principal amount again, but the market is falling, you have to invest at a lower interest rate. This reduces the chances of profit.
How Can You Manage Investment Risks?
Diversification is Must
Diversification is very important for investment. You should always have more than one investment instrument in your portfolio. For example, invest both in bonds and equities.
Asset allocation is Needed
Different assets should hold different proportions in your portfolio. This allocation should meticulously be done after assessing your investment time horizon, risk tolerance, and investment objectives.
For example, if you are an aggressive investor, your portfolio might be divided into 90% equities and 10% bonds. This is because equity provides a high return while facing risks but panic is never the option.
Portfolio Rebalancing is Crucial
Rebalancing your portfolio to balance the risks is a crucial aspect of investment. It also gives you the alternative to buy cheaper assets or sell assets that might be doing well. Every act is purely done to get more profits.
Fun is in the Long Run
Financial markets are volatile, prices can rise and fall anytime and for indefinite periods. If you have a short-term mindset you might lose, but with a long-term approach these shares always pick up their pace. Hence, you need to stay calm and be patient to gain these profits.
The Bottom Line
Investment does not need to be complex, if you do not understand something, ask an expert. Remember, assets like derivatives or exotic. If the anticipated returns are high, so are the risks involved. In addition, they are also levied with high fees.
You can start with simple investments like index funds or ETFs to invest at a lower fee. You can also save on investment fees with the help of Robo advisors. The key is in researching and thinking thoroughly before investing!